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It's Worth Being Picky WORKING CAPITAL 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 business. 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 balance sheet 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 accounting 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 assets 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 inventory 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 management 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 financial statement 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 cash-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, accounts receivable, be on the books at closing. A seller may a non-current asset is turned into cash inventories 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 accounts payable, 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.
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