What aspects of working capital should parties to a transaction be able to dispute?
In my prior posts in this series, I argued that the parties to a deal should not just settle for the trailing twelve month average in calculating target working capital and that the working capital adjustment should not be considered purchase price. In this post, I will give my perspective on how the parties should define working capital in the purchase agreement and discuss the parties ability to dispute working capital calculations.
Calculating Working Capital
In many purchase agreements, the parties will define working capital simply as current assets minus current liabilities. Not all businesses, however, have the same current assets or current liabilities. Companies that provide services, e.g., consulting firms, may not have any inventory. By simply defining working capital as any possible current asset under GAAP minus any possible current liability under GAAP, the parties are allowing for unnecessary disputes to arise.
Given that target and estimated working capital are prepared from the seller’s financial statements, it is much more precise to look at the balance sheet of the business and to specifically list out the appropriate line items that encompass current assets and current liabilities of the business being sold. (As discussed in the first post, the parties may disregard items like cash, taxes payable and the current portion of long-term debt.) By doing so, the parties minimize the possibility of a dispute if, for example, the buyer tries to introduce some current liability line item that was not used in calculating the target or estimated working capital. Conversely, specifically listing out the appropriate current asset line items eliminates the ability of the seller to dispute buyer’s calculation of closing working capital by introducing some current asset that wasn’t used in calculating target or estimated working capital.
The other aspect of calculating working capital that can be provided with precision and rarely is, thus leading to disputes, are the accounting principles used to calculate the value of the applicable current assets and current liabilities. Many purchase agreements default to “calculated in accordance with GAAP.” The problem is that GAAP allows a fair amount of discretion. One easy example to illustrate this point is how inventory is calculated, which can be done by using either LIFO or FIFO. Depending on the method used, the value of the inventory on the closing statement can vary significantly.
Some agreements attempt to avoid this problem by stating that the items of working capital will be “calculated in accordance with GAAP applied consistent with the Seller’s past practice.” This formulation is certainly better than simply “in accordance with GAAP” but still is not as precise as identifying exactly what GAAP principle, including whether it’s a year-end or interim accounting principle, was used to calculate each agreed upon line item of working capital. In fact, if you specifically identify the accounting principle used, it doesn’t even need to be in accordance with GAAP.
In short, many, if not most, working capital disputes can be eliminated if the parties simply define working capital to be “the Current Assets of the Business set forth on Exhibit X minus the Current Liabilities of the Business set forth on Exhibit X, in each case as determined in accordance with the accounting principles set forth on Exhibit X.” Then, the parties create Exhibit X and specify exactly what line items of current assets and current liabilities will be used and exactly what accounting principles will be used to calculate the values of those line items.
What Can Be Disputed
If the parties don’t particularly identify the components of working capital or the accounting principles to use, then obviously those items can be disputed by either party in arriving at actual working capital. Once those variables are eliminated by the careful drafting suggested above, however, very little is left to dispute.
Therefore, I add (or try to add) to my purchase agreements the concept that while reviewing the closing working capital statement delivered by buyer, the seller may only dispute either (1) that final working capital was not prepared in accordance with the agreed upon accounting principles or (2) whether any of the calculations prepared by buyer contain mathematical errors on its face. A necessary subcomponent of these disputable items is that the buyer has all the relevant information in calculating any item of working capital. Thus, for example, if buyer just completely missed an outstanding account receivable, that of course can be disputed as either a failure to use the appropriate accounting principle or a mathematical error.
Other than a negative visceral reaction to being limited on what can be disputed, no opposing counsel representing a seller has ever identified what else could be disputed if the components of working capital and the accounting principles are locked down. That said, as buyer’s counsel, if everything is locked down as suggested, you may not need this additional provision as there is nothing else to dispute.
So far, we have posited a situation where the seller prepares the estimate of closing working capital, the buyer calculates the closing working capital true-up and delivers that calculation to the seller, and the seller either accepts or disputes that calculation. Some agreements will even provide that if the buyer does not provide a closing working capital statement within the agreed upon timeframe after closing, the seller’s estimate becomes final.
One special circumstance to consider is where the seller’s pre-closing estimate understates working capital. If the buyer’s post-closing calculation of working capital shows that the seller underestimated working capital at closing, the buyer may either submit a statement that agrees with seller’s calculation or simply not provide any calculation, hoping the seller’s estimate becomes final. A seller should consider providing in the purchase agreement that if buyer fails to deliver its post-closing calculation of working capital, the seller can provide its own post-closing calculation, which would then be treated as if seller disputed a calculation delivered by buyer. If the parties are truly trying to ensure that the appropriate amount of working capital is delivered at closing, i.e., the target working capital, this type of provision is only fair so as to encourage the seller to be as careful as possible in leaving the correct amount of working capital. Otherwise, a seller will always be motivated to under deliver working capital at closing and have to pay a true-up to buyer.
In the last post of this series, I will consider how the working capital true-up should be modified if the selling shareholders are retaining an equity interest in the company sold and give my perspective on the concept of delivering the business on a cash-free basis as it relates to working capital.