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WORKING ADJUSTMENTS

example, six or 12 months). Alternatively they may use a pre-signing balance-sheet It’s worth date as a reference. The calculation of target working capital will depend on the historical and projected growth of the . The parties will also consider seasonality or other being picky industry trends that affect working capital. For example, if the business is seasonal, a Complex but important, working capital adjustments can particular month could be a high or low point in the business’ cycle. It may be more trip up even the most amicable deal. Here are some tips appropriate to use an average than to choose a particular month as the target working ost private acquisitions start adverse change or change in customer capital amount. Conversely, the trailing with at least one happy relations. Thus, the incentive and working-capital average may not be the best event – seller and purchaser opportunity for mischief is great. measure for a business that has grown over agree on a price. That event As the draftsperson of the acquisition the recent financial period. The working Mquickly leads to a new negotiation, as they agreement for the transaction, it is capital needed to operate the business at realise that the of the business imperative that the lawyer coordinates early closing will be greater than the historical is going to change between signing and and often with the client and its accountant trailing average, and the price the buyer pays closing. Income will be earned (or lost), regarding the working capital adjustment. is based on the projected continued growth. payables and receivables will go up or down, One of the lawyer’s responsibilities is to Again, the accountant’s input is critical for and capital expenditures will be made. From have the accountant review and comment determining the appropriate target amount. a financial perspective, the target business on each draft of the purchase and sale When the parties have reached an will not be the same as it was on the date the agreement. Implementing agreement, the drafting of the working business deal was made. With that in mind, principles in legal documents is not always capital adjustment can begin. a purchaser wants to make sure that it an easy task, and substantive issues can be receives a business whose working capital is lost in the translation. The lawyer should Methodology consistent with ordinary operations. A seller, also review the business and accounting The focal point of any working capital on the other hand, wants to ensure that it due diligence memoranda that are prepared adjustment is the choice of accounting retains any excess working capital. So they in connection with the transaction. These methodology by which the adjustment will make a new deal. Such is the nature of the memoranda will provide the basic be determined. The methodology is defined working capital adjustment. framework for calculating working capital. as the accounting principles, methods and Working-capital provisions are not They will probably include a detailed practices of the target business. They must simple to draft, and they are the most working-capital analysis, which identifies be consistent with Gaap. Failure to have a frequent source of post-closing disputes. the components and risk areas of the clear accounting methodology is a recipe for Problems arise because specialists from two working capital. They should also feature a working-capital dispute. different fields, law and accounting, must any deviations from generally accepted The working capital calculation should cooperate closely to make the calculation accounting principles (Gaap) and special be determined in accordance with the work. Problems also occur because the or liabilities that need to be taken accounting methodology used in preparing provisions vary depending upon the nature into account in the working capital analysis the target company’s most recently audited of the business. Finally, problems arise (for example, deferred revenue or liability balance sheet. As far as is possible, these because of the precision required to reserves). principles should be applied consistently, measure working capital changes. They As part of the working capital and in accord with Gaap. Although Gaap is differ from the abstract concepts that other adjustment, it is necessary to calculate a open to interpretation and may allow for acquisitions deal in, such as a material target working capital. This represents the more than one outcome, the aim is to normalised level of working capital of the create a precise accounting methodology. target business before the closing, on which Reference to the audited balance sheet the parties have agreed. It also represents promotes precision in a number of ways. “Problems arise the working capital at the closing date of First, the notes in the audited financial the transaction. The target working capital statements describe the application of the because specialists is measured against the closing working target business’ accounting methodology; from two different capital to determine whether an excess or a for example, the notes will describe shortfall has occurred. The measurement whether the is calculated on a fields, law and also helps determine adjustments to the Lifo or Fifo basis (last-in-first-out or first- purchase price. in-first-out). The working-capital accounting, must calculation will follow the treatment The target amount outlined in the financial statements. In cooperate closely As part of the overall business deal, the seller addition, the auditor of the target business and the purchaser will agree on a target has already validated this accounting to make the working-capital amount. They calculate it methodology. As a private company, the by determining the target business’s average business is not subject to legal reporting calculation work” working capital over a defined period, before obligations, and the has signing an agreement or term sheet (for prepared monthly and quarterly unaudited www.iflr.com IFLR/January 2008 1 WORKING CAPITAL ADJUSTMENTS balance sheets that are solely for internal purposes. The methodology that the Working capital changes differ from management has used is unlikely to be as “ clear and consistent as the auditors’ abstract concepts such as a material methodology in preparing the audited financial statements. adverse change. The incentive and The audited financial balance-sheet approach also complements the audited opportunity for mischief is great and warranty. Together ” they ensure that the historical audited financial statements “present fairly in all agree are a further refinement of the concept far less precise than matching material respects the financial position of accounting methodology, which addressed target and final working capital), but which the company” and “were prepared in the details of the transaction. For example, increases -in-hand. The seller obtains accordance with Gaap, applied on a regarding inventory, the accounting the cash to the detriment of the purchaser’s consistent basis [with earlier periods]”. methodology will dictate whether the parties interests. The buyer’s protection against Seller and purchaser gain an added layer of use Lifo or Fifo. The parties could agree on this lies in setting the peg for the target protection if the purchase and sale special rules to determine a precise amount. If the peg is correct, the seller has agreement provides that changes in obsolescence policy or to determine the no incentive to build up and then extract accounting methodology made after the write-downs for obsolete inventory. cash from the business because it will have issuance of the audited working-capital Liability reserves are an area where to return the cash to the purchaser as part financial statements will have no effect, special balance-sheet rules can be used to of the working-capital adjustment. even if Gaap has required them. Prevention introduce Gaap clarity. Under Gaap, the If the parties calculate a working-capital of such changes allows for a so-called apples ability to reverse reserves is open to estimate shortly before closing, they to apples comparison, and the target interpretation. A party can reverse the eliminate the seller’s ability to extract cash working capital is calculated based on the reserves even if it has not made a cash pre-closing and return it some months later audited balance-sheet methodology. settlement. The inclusion of a liability when the working capital has been reserve in the computation of target determined. The exclusion or inclusion of Line items working capital reduces the target working- cash in the working-capital calculation The next step in formulating the working capital amount, because liabilities decrease should not make a difference to the parties, capital adjustment is to define working working capital. If a party reverses a subject to the float issue (discussed below). capital. A simple Gaap definition of working liability reserve that it has not paid, the The calculation relates to the manipulation capital is current assets minus current amount of closing working capital will of current assets and current liabilities to liabilities. Current assets include cash and increase because the liability will no longer create cash; the theory does not apply when cash equivalents, , be on the books at closing. A seller may a non-current is turned into cash and, in some cases, prepaid reverse the reserves to manipulate the because by definition, the working-capital expenses. Current liabilities include closing working-capital calculation in its adjustment does not cover non-current , compensation and favour. A simple but effective way of assets. benefits accrued, and income taxes and dealing with this is to prohibit the reversal Consider a situation where the working- other liabilities accrued, to be paid within of reserves, except in cases where the party capital computation does not include cash. one year of the date of the balance sheet. A can satisfy the liability for which the reserve If a seller increases the cash by stretching good starting point for deciding which assets was created by a cash payment, on or before payables or accelerating the payment of and liabilities to include in the working- the closing date. accounts receivable, there will be more capital calculation is a review of the target’s cash. But the increased cash will reduce the audited historical balance sheet and the Cash amount of working capital that the seller accounting due diligence report. Rather Cash is a ubiquitous line item, and it often delivers at closing. Stretching payables than rely on the general Gaap working creates confusion. Buyers and sellers increases the side of the capital definition, the parties should specify sometimes argue about whether to include it working-capital computation (more the line items that will feature in the in the working-capital computation. payables), and reduces the net working definition. The working-capital definition Because most private transactions are capital. Acceleration of the accounts should expressly state that the calculation conducted on a cash-free, -free basis, the receivable will result in fewer current assets will not include assets or liabilities other seller is entitled to the benefit of the target and a reduced net working capital. If the than the enumerated line items and special business’s cash. A seller may realise this working capital includes cash, by contrast, balance-sheet rules (discussed below). This benefit by using cash-in-hand to repay debt acceleration of accounts receivable will approach is a good way of maintaining and increase its equity value; alternatively, result only in a shifting to one consistency. It ensures that neither party will the seller may pay a dividend before closing, – cash – from another current asset – introduce a class of assets or liabilities that is if the pre-closing covenants in the agreement accounts receivable. Because the not expressly defined as a component of do not prohibit it from doing so. manipulation of current assets and current working capital. Some purchasers argue that cash should liabilities to create cash has no net effect on be included in the working-capital either party, including cash in the working- Special rules computation. The exclusion of cash may capital adjustment to deal with this issue The parties can introduce special balance- encourage the seller to manage the target brings no benefits (this assumes that the sheet rules for the contract, to ensure that business in a way that technically complies working-capital adjustment is a dollar-for- the deal is captured. The rules on which they with the covenant’s ordinary operation (a dollar adjustment, and not measured

2 IFLR/January 2008 www.iflr.com WORKING CAPITAL ADJUSTMENTS

against a band or range of working capital). consequences if the working-capital cash in the working-capital adjustment so Cash, of course, can be created in a computation did not include cash: a cheque that it does not have to contribute variety of other ways – by failing to make or is written for an account payable additional equity or borrow additional slowing down spending on capital immediately before closing. At closing, the funds (at an additional cost) to pay for that expenditures, by R&D, or by advertising. seller removes all the cash from the business excess. From the purchaser’s perspective, inclusion (the -statement cash balance), In conclusion, to accurately accomplish of cash in the working-capital computation including cash needed to cover the cheque in the zero-cash, zero-debt business deal, the does not solve the problem. Take the question. The application of the accrual- working-capital calculation should include example of deferring a capital expenditure. based accounting methodology requires a cash. Including cash avoids the float issue. If the expenditure is made, Gaap requires reduction of the amount payable to reflect It means that the seller receives all the cash that the cash account be reduced by the the fact that the cheque was written, even at closing. When the parties decide on this approach, they should see that the target working capital does not include cash in “A precise formulation diminishes the excess of the business’ normal needs. Debt likelihood that the parties will dispute the Another line item that needs to be working-capital adjustment – and the considered separately is indebtedness. Indebtedness has two components: the memory of both parties will be of happy current portion of indebtedness, comprising all payments due within twelve months of faces at deal closure the balance-sheet date; and the non-current ” (or long-term) portion, comprising indebtedness not due within the twelve amount of the expenditure. Gaap also though there is no cash to cover payment of month period. Because most private deals insists that a corresponding capital the liability. It also requires a simultaneous are conducted on a debt-free basis, the improvement be booked as a long-term reduction of the cash balance. But because purchase and sale agreement should provide asset (a capital asset). If the computation of cash is not part of the working-capital that the relevant party repay with the working capital has included cash, the adjustment, the accounting entry for the purchase price proceeds at closing; amount of cash is increased and this cash reduction is made solely for book- outstanding debt reduces the equity value. benefits the seller. It does not reduce accrual purposes. Consequently, the The effect on the working-capital working capital in the same way as the purchaser is paying the seller more (because computation is that indebtedness will be examples of the accounts payable and the seller received the benefit of all of the paid at closing, and the closing calculation accounts receivable described above, target’s cash), and the working-capital must exclude the current debt portion. This because the failure to make the expenditure computation no longer mentions liability avoids double dipping relating to the does not affect current assets or liabilities. for the payable (thereby increasing closing repayment of indebtedness. To maintain The only protection available to the working capital). Although it is possible to consistency between the target and the purchaser regarding these expense items is create balance-sheet rules to address the float closing calculations, the target working- to obtain a separate purchase-price issue, the simplest approach is to include capital calculation must exclude all repaid adjustment; it may also construct narrowly- cash as a line item in calculating the target indebtedness. tailored, ordinary-course covenants. and closing working capital. Unfortunately, the debt-free concept is From the seller’s perspective, the not always as clear cut as it sounds. It is The float issue working-capital adjustment should feature common for some debt to remain Including cash in the calculation of both the excess cash as a safeguard against leaving outstanding after closing. Low interest-rate target working capital and the closing cash behind at closing. Several events can industrial revenue bonds and capitalised working capital does, however, remedy the result in cash being unintentionally left leases are two examples. If the purchase and float issue. The float is the difference that behind. The operation of the seller’s cash- sale agreement does not provide for a exists at any time between the accrual cash management system and the realisation of separate retained indebtedness-adjustment balance (the cheque-book cash balance) and sales made immediately before or on the to the purchase price, the parties normally the bank cash balance (the bank-statement closing date drive the cash balance at take the main amount of retained cash balance). Floats refer to the time that it closing (the balance will probably not be indebtedness into account in arriving at the takes for incoming checks (receivables) to known until after closing). Including cash purchase price. The agreement should also clear and be converted into cash and for as a working-capital line item ensures that include the accrued interest portion of the outgoing checks (accounts payable) to clear the seller obtains the benefit of all cash, retained indebtedness as a current liability after being cashed by third parties. Consider whether extracted as a dividend or through for working-capital purposes, to reflect this example: the seller writes a cheque to the working-capital adjustment. The accurately the cost of the business between pay an account payable. Gaap requires a purchaser should avoid a deal structured on signing and closing. reduction in cash and a corresponding a debt and cash-free basis because the seller reduction of the amount payable. From a is entitled to keep the excess cash, although The long view working-capital perspective, the transaction that depends on whether cash is trapped in Special balance-sheet rules treat liabilities is a non-event because offsetting entries foreign subsidiaries or serving as a deposit customarily treated as long-term, under Gaap feature on the liability and asset side of the for obligations that are in dispute. The (and thus not part of a Gaap working-capital balance sheet. But consider the purchaser may cap the amount of excess definition) as liabilities in the working-capital www.iflr.com IFLR/January 2008 3 WORKING CAPITAL ADJUSTMENTS calculation. Deferred revenue is a good deductions simply reduce taxes, the issue is are not normal working-capital items. As example. Deferred revenue arises when a unclear because pre-closing taxes are with the tax benefits described above, customer pays in advance for services or generally the seller’s responsibility. Problems deferred taxes may not be realised in the goods. If the customer needs the service or arise if the target is not a taxpayer, or if the future. good more than one year after the date of the deductions exceed the pre-closing income. A After the parties have determined the line calculation of working capital, Gaap treats the purchaser would be reluctant to pay cash for items, accounting methodology and special portion of the prepayment attributable to the these deductions, because the benefits that it balance-sheet rules for calculating the period after the one-year anniversary as a derives from them are not known at closing; target and closing working capital, they long-term liability. The typical working- further, the purchaser cannot draw on the should attach a mock working-capital capital definition would not pick up the benefits immediately, if at all. If the target calculation to the purchase and sale portion of deferred revenue that is classified as business has net operating losses that agreement. It will be an excellent reference long-term. Unless the purchaser deducted eliminate or delay the purchaser’s ability to point if disputes arise, particularly because deferred revenue in setting the purchase price, use the deductions, or if the post-closing business people often find visual or created another adjustment mechanism, capital structure is highly leveraged and representations more accessible than prose. the working-capital adjustment should future interest deductions will provide a tax Working-capital adjustments can be include all such revenue, no matter how shield, no purchaser would want the excess ambiguous. Creating a precise formulation classified, as a liability. It must match the cash deductions to increase the purchase price. A of the working-capital adjustment is with the assurance that the revenue created purchaser could agree to provide a separate challenging and time-consuming. But it will be performed. post-closing adjustment for tax benefits diminishes the likelihood that the parties when they are realised. But this approach will dispute the working-capital adjustment Taxes means that the seller remains interested in – and the memory of both parties will be of Taxes also create the need for special the buyer’s affairs. The calculation is happy faces at deal closure. balance-sheet rules. One of the trends, at complex and vulnerable to attack. To avoid least in the pre- crunch, seller-friendly confusion, the balance-sheet rules should environment, is for the seller to include a address whether working capital will be By Angelo Bonvino and Kenneth M Schneider, current asset in the closing working-capital determined with or without consideration of partners at Paul Weiss Rifkind Wharton & calculation for any tax benefits created by the transactions outlined by the sale and Garrison, and John R Monsky, general counsel the repayment of debt, the cash out of purchase agreement. and partner at Oak Hill Capital Management options, the payment of bonuses and other Another tax area that requires special payments made at the closing. The seller balance-sheet rules is deferred taxes. The argues that it should have the benefit of parties will generally exclude deferred taxes In some jurisdictions, this reprint may be these deductions because it is funding the from their calculations because deferred considered attorney advertising. Past payments by reducing its equity purchase taxes are the result of the difference representations are no guarantee of future price. If the target is a taxpayer and the between tax and , and outcomes.

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