Working Capital Adjustments in M&A Transactions

An evaluation of a company’s working capital is a critical piece of merger and acquisition (M&A) transactions. A detailed financial evaluation must be conducted to determine the financial and legal expectations of both parties involved in the transaction. Working capital adjustments in M&A are key in situations where the working capital of the business being acquired has changed before the deal has been finalized. These adjustments are often used as a basis to change the initially agreed-upon purchase price.

What Is Working Capital?

When a potential buyer is considering a merger and acquisition transaction, they will estimate the average net operating working capital (NOWC) necessary to maintain the current revenue taken in by the company. In many of these transactions, the buyer will require the business to provide a designated net working capital amount along with the fair market value of the capital assets of the business to support the overall enterprise value calculated for the business.

In more simple terms, the NYU Stern School of Business defines a company’s working capital as the difference between current assets (such as cash, accounts receivable, unpaid customer bills, etc.) and current liabilities. This figure measures a company’s liquidity, operational efficiency, and short-term financial health status. Companies with positive working capital often have major potential for growth and investments. Conversely, a company with liabilities that exceed its assets (negative working capital) is more likely to struggle to grow or pay back creditors and may be at risk of going bankrupt.

What Is a Working Capital Adjustment?

A working capital adjustment is an adjustment of the purchase price based on the working capital of the target company or business in a merger and/or acquisition. Generally, companies need a minimum amount of working capital to continue with their operations. The party acquiring the target company must ensure that the target company has enough working capital after closing to continue its operations. When the working capital is insufficient, the buyer may need to invest additional cash into the business, which increases the effective purchase price. To account for this increase, the buyer may require a working capital adjustment, which lowers the purchase price if the working capital of the target company is below a certain level at the closing date.

For working capital adjustments in M&A, both sides will agree on a working capital target that the acquired company should have at the time of closing. Shortly before closing, the seller will provide an estimate of the amount of working capital it believes the target company should have at closing. If the seller’s estimate is higher than the working capital target, the purchase price will be increased based on this excess amount. If the estimate is lower than the working capital target, the buyer will receive the difference as a reduction in the purchase price. After closing, the buyer will calculate the amount of working capital the target company had at closing. If the buyer’s calculation differs from the seller’s estimate, the purchase price will be adjusted.

When Is Working Capital Calculated?

The required working capital figure is typically calculated during the letter of intent stage of the transaction process. In many of these transactions, the letter of intent is one of the first documents discussed between the two parties. It functions as a written record of the parties’ intent to arrive at a deal and a summary of all of the potential deal’s material terms.

The letter of intent is primarily a starting point for this process, and it is not legally binding. This document helps outline the main terms of the deal and ensure that there are no potential roadblocks for either party. However, extensive research and negotiations usually take place for an extended period after the letter of intent has been drafted. This part of the process is known as “due diligence”, and the working capital figure may be redefined at this point.

When Do Working Capital Adjustments Happen?

A working capital adjustment can be made at various points during the negotiation and transaction process. While they can happen at the closing date, they typically take place between 90 and 120 days after closing. This time frame gives the buyer’s auditors enough time to review the calculations. At this point, all accounts are closed, which allows the buyer’s team to calculate a more accurate working capital figure. This final figure is compared with the original working capital estimate, and any adjustments are based on differences between these two numbers.

Working Capital Adjustment Considerations for Sellers

The owner of the business to be sold during an M&A transaction should make sure they understand how their working capital estimate was calculated. In addition, it is critical to be aware of the true average net operating working capital (NOWC) necessary to maintain the current levels of revenue. Sellers should also be aware that buyers may attempt to overestimate this number as a tactic for justifying a downward working capital adjustment before closing.

Finally, sellers should be sure to include all current assets in their working capital calculations. This may include certain expenses that have been written-off for tax savings. In an M&A transaction, some of these expenses and supplies, along with prepaid expenses, should be reclassified as inventory and be included as part of the current assets.


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