M&A Agreements: Working Capital & Post-Closing Adjustments

An important part of a typical merger & acquisition (M&A) deal for both sides is the issue of net working capital. A simplified definition of net working capital is a company’s current assets (less cash) minus its current liabilities (less debt). Or, in even simpler terms, the amount of money it takes to generate the income that a buyer might expect during a cash cycle. This is crucial for an optimal transaction but is often glossed over by both the seller and buyer during an M&A.
In smaller transactions, often a Buyer does not get working capital in the transaction- they merely get the assets (excluding cash) and no liabilities. Then, the buyer needs to provide the working capital (i.e., the money to turn those assets into profit). However, in larger deals, buyers almost always want to take over the business with some agreed upon level of working capital.

Net Working Capital
A company’s net working capital is often referred to as operating liquidity, which is the assets and resources needed to carry on operations after ownership is transferred. The net working capital of a target company is almost always a “cash-free, debt-free” figure; the specific method for calculating a particular company’s net working capital is often found in its asset-purchase or stock-purchase agreement. Net working capital often consists of the following assets:

  • Accounts receivable
  • Inventory
  • Prepaid expenses
  • Other assets likely to be liquidated within 12 months
  • Liabilities often included in determining net working capital include:

  • Accounts payable
  • Wages
  • Taxes payable
  • Other debts expected to be paid within 12 months
  • Conversely, the things that are typically excluded from the net working capital are:

  • Cash and Cash Equivalents
  • Long-term and short term debt (i.e., loans, lines of credit, etc.)
  • Target Working Capital
    The buyer in any M&A transaction will want to have enough operating liquidity on hand and will negotiate a “target” with the seller. This figure is the amount the buyer would like to have at the closing table in order to carry on operations and generate revenue. Looking back at the average net working capital from the same point in the previous 6-12 months can be helpful for buyers to come up with an accurate target working capital.

    As of the day of closing, it’s nearly impossible to determine whether the Sellers has in fact delivered to the Buyer an amount of working capital equal to the target amount. This is so because it often takes some time after the fact to reconcile a balance sheet to determine what the working capital was on a particular day. Thus, it is expected that there will be some variation between the target working capital and the working capital actually provided to the buyer by the seller at the closing. To help remedy this discrepancy, an escrow account will often be created to hold an amount that will help the Seller assure that the target amount will, in fact, be delivered. Then, sometime after the closing (often 45-90 days after), the parties do a “true-up” or reconciliation of the working capital actually delivered at closing versus the target amount agreed to be delivered. If the Seller came up short on their delivery at closing (i.e., the target is greater than the actual working capital), then the Buyer typically uses the escrowed funds to make themselves whole. Conversely, if the Seller over delivered at closing (i.e., the actual amount of working capital exceeds the target), then the Seller will (typically) not only receive all of the amount being held in escrow, but also the difference between the actual working capital and the target.

    Net working capital amount provides benefits for both the buyer and seller of an M&A. However, it sometimes is not given the proper consideration. Doida Law Group is experienced in negotiating all parts of M&A transactions, including the target working capital and eventual adjustment. Fee certainty is one thing we provide our clients through our unique billing structure. If you have any other questions about getting started with us, call 720.306.1001 to get in touch with a member of our team today.

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