Should parties to a transaction use the working capital true-up to renegotiate purchase price?
In my prior post in this series, I offered my perspective on how the parties to a deal should view target working capital. I argued that they should not merely use the trailing twelve month average of the actual working capital of the business acquired, but should put forth the effort to calculate the working capital necessary to run the business without the infusion of outside capital. In this post, I will describe the mechanics of a working capital true-up and discuss why the parties should not consider the working capital adjustment as an adjustment to purchase price.
While variations exist, the following seems to be the most common working capital true-up mechanism. A few days prior to the proposed closing, the seller will deliver to the buyer the seller’s estimate of the amount of working capital that it expects to deliver at closing. In many cases, this estimate will be calculated by both parties as they are working to arrive at target working capital, and thus this estimate should very rarely be a surprise.
At the closing, the estimated working capital is compared to the target. If the estimate is higher than the target, the buyer will pay the seller for the additional working capital, or it will be paid out of the business. If the estimate is less than the target, the buyer will reduce the amount paid at closing to seller. Presumably, the buyer would then inject that difference into the business as, again, the target working capital is supposed to be the amount necessary to fund the daily operations of the business.
Sometime after the closing, after the accounts of the business for the pre-closing period have settled out, the buyer will calculate the working capital actually delivered by the seller at closing. Typically, the buyer will be given 60 to 90 days to complete this calculation. Once the buyer delivers its calculation of actual closing working capital, the seller will have some period of time (between 30 and 60 days after buyer delivers its calculation) to review buyer’s calculation and dispute or accept its accuracy. If the seller disputes the buyer’s calculation of closing working capital and the parties cannot resolve this dispute, they may engage an independent accounting firm to arbitrate the dispute.
Ultimately, a closing working capital drops out of this process and is compared to the estimate. If closing working capital is higher than seller’s estimate, buyer will pay to seller the amount of that difference, or it will be paid out of the business. If closing working capital is less than seller’s estimate, the seller will pay to buyer the amount of that difference. Again, presumably buyer would inject that payment into the business. Once working capital is finally determined, the parties typically may not revisit this topic, and the working capital true-up is complete.
While this process seems straight forward in theory, in practice it rarely is. The remainder of this post and the following posts in this series will describe some common issues that arise in this true-up process and provide some suggestions on how these problems might be avoided.
Working Capital Is Not Purchase Price
In describing the mechanics of the working capital true up, I deliberately avoided characterizing the payments of the differences between the closing estimate to target and the final working capital to the closing estimate as purchase price adjustments. Only the headline purchase price should properly be considered the purchase price when the parties calculate the target working capital and run through the true-up mechanics.
The adjustments made at closing for the working capital true up, as well as to pay off debt or transaction expenses or to pay the seller for excess cash, are simply for funds flow purposes. While debt and transactions expenses may be paid out of the purchase price proceeds, their payment doesn’t lower the enterprise value of the business. (I do appreciate that for tax and accounting purposes, these payments, as well as other expenses outside of the purchase agreement, could affect what seller and buyer will report as purchase price on their books and records, and that they will likely report different purchase prices.)
Let’s view these payments a different way to illustrate the point I’m trying to make. For simplicity, let’s first just consider debt and transaction expenses. The buyer could pay the seller the headline purchase price, and then the seller could take these funds and pay off debt and transaction expenses. For efficiency purposes, and because the buyer wants to make sure these amounts are actually paid, however, the purchase agreement will call for these amounts to be paid out of the purchase price proceeds, thus reducing the amount paid to seller. But this isn’t a purchase price reduction.
The same is true for the working capital adjustment. If the seller doesn’t leave enough working capital in the business, the working capital adjustment will be treated like debt or transaction expenses as discussed above. If the buyer pays the headline price to seller, seller would then have to make a payment of the working capital shortfall into the business, which is a capital contribution, thus increasing seller’s basis in the business. If the buyer pays the net amount to seller, which is typical, it again is just for funds flow simplicity. It does not change the purchase price.
If the seller leaves too much working capital in the business at close, the buyer, either directly or from the acquired business, pays the seller for that excess working capital. If the buyer pays it directly, that payment will increase purchase price, i.e. buyer’s basis in the business, because it can be viewed as buyer making a capital contribution in that amount to the business. If it’s paid out of the business, the buyer’s purchase price is the headline price. The seller’s perspective is different however, as seller has now received a return of capital, i.e., the excess working capital, from the business, plus the purchase price from the buyer.
The point of this discussion is the following. A shortfall or excess of working capital is just that, it should not be considered purchase price. Having arrived at an enterprise value for the business, neither party should then try to use the working capital mechanism to recut the deal price. The working capital adjustment, up or down, is just a mechanism to make sure the business has sufficient capital for the daily operation of the business without infusing outside capital. If it’s a positive adjustment, buyer should not feel as though it has paid a higher purchase price, and vice versa. If it’s a negative adjustment, seller should not feel as though it has been paid less. Seller sold a business with deficient working capital (maybe because it paid itself too much out of the business) and is simply making the business whole.
Similarly, because the target working capital is supposed to reflect the amount of capital necessary to operate the business, the goal of the working capital adjustment should be to make sure that amount of capital is in the business at closing. So, for example, while a collar around the target working capital may make sense to short circuit disputes over immaterial amounts, once the collar is exceeded, the adjustment should be to target. The collar should not act as a deductible and thus affect purchase price. Similarly, a cap on the working capital adjustment just makes no sense as this truly would be a purchase price reduction. Any similar limitations on the working capital adjustment should also be viewed with a jaundiced eye.
In the next post, I will discuss my perspective on how to define working capital and what items the parties should be able to dispute in the calculating closing working capital.