The Working Capital Adjustment

The working capital adjustment is an important part of most merger and acquisition (M&A) transactions. A working capital adjustment adjusts the purchase price of the company based on the actual working capital delivered at closing. If working capital is above the working capital target, the purchase price increases, and if the working capital at closing is below the target amount the purchase price decreases. While this might sound like there is a “winner” and a “loser,” when properly structured, working capital adjustments are buyer-seller neutral.

Holistically, the working capital adjustment helps make sure the company’s operations run as usual from the deal’s early stages up until closing. Without working capital adjustments in place, the seller could manipulate the balance sheet, causing the buyer to pay more in the transaction. Likewise, if the balance sheet strengthens between the letter of intent (LOI) stage and closing, the buyer would get this benefit without paying for it. The working capital adjustment resolves these conflicts.

There are three key components to a successful working capital adjustment: how do you define working capital, what is the target working capital value, and closing estimate and post-closing true-up.

What is Working Capital and How to Set a Working Capital Target

Defining working capital itself is the foundation of a working capital adjustment. In simple terms, working capital is a company’s current assets subtracted by its current liabilities. Cash, inventory, unpaid invoices, and accounts receivable are examples of a company’s assets. Liabilities include accounts payable, short-term debt payments, unpaid wages to staff, and more. Working capital gives insight into a company’s short-term financial health and operational efficiency. Generally, higher working capital indicates success and a positive outlook: that the company has the extra cash to invest in growth or take on opportunities. Conversely, negative working capital could indicate that the business is struggling to grow or pay back debts, or even is at risk of bankruptcy. Put in an equation, working capital looks like:

Working Capital = Current Assets – Current Liabilities

However, every business is unique, and most transactions are structured as cash-free and debt-free. A business might be seasonal, or it could include percentage of completion accounting. A successful working capital adjustment begins with the buyer and seller agreeing on exactly what should be included— and excluded from the definition. Early on in the acquisition process, the buyer and seller determine how much working capital is necessary to maintain healthy business operations. This figure is frequently defined during the letter of intent (LOI) stage, wherein the terms of the deal are outlined in a legally non-binding document. This working capital amount is sometimes redefined during the due diligence stage of the acquisition process, when the buyer investigates the business more thoroughly.

After agreeing upon the working capital definition, the next step is agreeing on the target value. If the business is perfectly stable, this is easy to do: just take the current working capital value and set that as the target. However, some businesses are seasonal, or have other variables. For these businesses, calculating working capital— as defined— at month end for each of the previous twelve months, and averaging the value, is often a good methodology to set the target value.

In its simplest form, working capital and its target could resemble the chart below.

Working Capital Definition and Value at LOI Date:

Working Capital Adjustment and How It is Calculated

When it is time for an acquisition to close, an estimated working capital adjustment is typically made at closing with a final true-up typically completed 90 to 120 days after closing— allowing the buyer and seller time to review and agree upon the estimated closing adjustments.

Below is an example of a working capital adjustment calculation. In the example below, the working capital delivered at closing is more than the target working capital decided upon at the LOI stage. As a result, the purchase price increases by the excess— in this case, $115,000. While the buyer pays more, the buyer also receives the additional working capital when business ownership begins. At the same time, the seller receives compensation for what they invested into working capital, ensuring they are paid the full purchase price.

Protecting Both the Buyer and the Seller

So, why is a working capital adjustment important? Without a working capital adjustment, the buyer risks paying more than the purchase price to cover the company’s lack of working capital. For example, if the seller were to “forget” to pay its bills, the company’s cash would increase but its working capital would decrease. The working capital adjustment protects the buyer from having to pay these bills in addition to the full purchase price. The adjustment also motivates the company to pay its bills as it normally would, as manipulating the balance sheet will not change the seller’s compensation. Effectively, working capital adjustments help ensure the company is run as usual from the letter of intent stage up until closure.

While in the example above it may look like the seller receives an additional $115,000 of consideration, the seller is actually neutral on the adjustment, as the table below shows.

Why Seller is Neutral Between LOI and Closing:

Working capital adjustments are crucial to ensuring the acquisition process runs smoothly. If you have any questions about working capital adjustments, do not hesitate to reach out.