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MONDAY, October 26, 2015 Working Capital Adjustments: At the Crossroads of Law and Accounting BIGSTOCK

orking capital adjustments are the nuts and bolts of working capital By Mark Thierfelder, often some of the most highly adjustments but also the nuances Christian Matarese, W negotiated provisions in a pri- thereof to avoid traps for the unwary. Anthony Caporrino vate company M&A transaction agree- M&A lawyers must be fluent with the and Jonathan Vanderveen ment. The provisions are complex and constituent elements of working capital involve a blend of legal and accounting in a particular business in order to prop- Mark Thierfelder is Chair, Corporate & Securities, and a concepts and standards and can have erly understand their client’s business partner and Christian Matarese is an associate at Dechert in New York. Anthony Caporrino and Jonathan an immediate impact. It is essential that objectives and to properly document Vanderveen are managing directors with Alvarez & Marsal. deal team members understand not only the business agreement. MONDAY, oCTOBER 26, 2015

Working capital is often crucial to the the components of working capital and the acquired business operates. Other operation of a business and can signifi- the details of the adjustment and relat- key factors to consider in establishing cantly affect valuation. Buyers often bid ed dispute resolution mechanics often a target include, among others, whether on an acquisition on a cash free, debt require a thorough understanding of the the acquired business: free basis, assuming an amount of work- business. These provisions require not • experiences seasonal shifts in work- ing capital sufficient to operate the busi- only a keen legal eye but also account- ing capital; ness at closing. The devil, however, is ing acumen. Furthermore, when disputes • experiences erratic changes in work- very much in the details. arise, they are often resolved by account- ing capital or operates in a commodity This article will explore the various ing experts as opposed to judges. Accord- driven business where commodity valu- issues M&A counsel will face when ingly, deal teams would be wise to involve ations may be subject to unpredictable drafting and negotiating working capi- both legal counsel experienced in such swings; and tal adjustments and highlight several matters and accounting advisors from • is experiencing significant growth or, potential “problem areas.” the outset. as a result of receiving payment prior to the delivery of product or services, What Are the Parties Trying to Achieve? operates with negative working capital. At its core, working capital is the A one size fits all approach does not Buyers typically want to protect difference between current assets work. Proper financial due diligence is against the depletion of working capi- and current liabilities. This, however, key to avoiding pitfalls. The relative tal after signing and ensure that an is the first trap for the unwary. importance of working capital to pur- acquired business has an appropriate The financial impact of the working chase price should be a guide to the amount of working capital. Adding capital and other purchase price level of diligence and negotiation the additional working capital at closing parties believe is necessary. Among oth- will effectively serve to increase pur- adjustments can be significant. er things, working capital due diligence chase price. Buyers also do not want can uncover trouble spots including to discourage sellers from operating in At its core, working capital is the dif- understated reserves, lack of sufficient the best interest of the business. For ference between current assets and reserves, or missing accruals (such as example, buyers do not want the “cash current liabilities. This, however, is the warranty, medical claims, vacations and free” nature of a transaction to provide first trap for the unwary. The financial bonuses), all of which result in higher a perverse incentive to discontinue impact of the working capital and other EBITDA calculations, a multiple of which making budgeted capital expenditures. purchase price adjustments can be sig- is often paid as purchase price consid- Sellers want to preserve cash and reap nificant. The definitions and methodolo- eration. the benefits of earnings sellers gener- gies used must be precise and work with Definition of Working Capital ated. As a result, the vast majority of potentially overlapping provisions, such One of the biggest mistakes made M&A transactions include purchase as adjustments for debt, cash and seller in defining working capital is lack of price adjustment for changes in work- transaction expenses. specificity. To avoid inadvertent wind- ing capital measured against a target. Target falls and post closing disputes, the Before the parties negotiate the com- parties to a transaction should define Components of Working Capital ponents of working capital and calcula- working capital precisely. The defini- And Calculation Methodologies tion methodologies, they need to agree tion should at a minimum specify the upon a target working capital. Setting the particular accounts (encompassing all A working capital adjustment is essen- target based on a specific historical date components of each included category tially a provision that tests closing date or set of financial statements is not nec- of current assets and current liabili- working capital against a negotiated essarily appropriate. Ideally, the specif- ties, including general ledger account benchmark or target working capital. The ics of the acquired business and relevant references) that are included in cur- target is set at signing and actual work- facts should be taken into consideration rent assets and current liabilities and ing capital is determined after closing. If before agreeing to a target. Target work- should also specify such accounts that working capital is higher or lower than ing capital may be influenced by many are excluded. the negotiated benchmark, the purchase things, including anticipated timing Careful attention should also be paid price is typically adjusted accordingly. between signing and closing, expected to several items that should possibly be This sounds straightforward; however, closing date and the industry in which excluded or may be dealt with in other MONDAY, oCTOBER 26, 2015

provisions of the purchase agreement. • in accordance with GAAP applied in The parties, consequently, often will Such items include the treatment of cash a manner consistent with the historical be served best by carefully and robustly and pre-paid expenses as well as the cur- practices of the acquired business; delineating the methodologies and pro- rent portion of long-term indebtedness • in accordance with GAAP applied in cedures to be used. In many cases, the and other debt components (particu- a manner consistent with the method- same methodologies and procedures larly if there are separate purchase price ologies and procedures used to deter- that were used to calculate the target adjustments with respect to such items); mine target working capital; working capital should be used in calcu- bonus accruals; deferred revenue and/ • by subtracting current liabilities lating the closing date working capital, or liabilities; the treatment of income from current assets (each as defined with such procedures specified in an taxes (particularly in the event there is a by reference to a list of included and exhibit to the purchase agreement. Tak- standalone pre-closing tax indemnity or excluded general ledger accounts); and ing such an approach and providing an the seller gets the benefit of income tax • in accordance with the methodolo- illustrative calculation of target working refunds); employee liabilities; customer gies, procedures and principles set forth capital—as opposed to merely defining deposits; related party receivables; past in an exhibit. target working capital as a number—will due receivables (and the likelihood they The agreed-upon methodology often reduce the likelihood of post-clos- will be received); whether the transac- should address instances where the ing disputes, or, in the event of a dispute, tion is a carve-out, a stock deal or an acquired business’s accounting prac- provide the party tasked with resolving asset deal (in which case, excluded tices (or certain of them) are not GAAP such dispute less room for independent assets and liabilities should likely also compliant or where accounting prac- interpretation and analysis. be excluded from working capital); any tices are GAAP compliant with respect Timing implications also need to be need for a physical inventory; and other to financial statements as a whole but considered. For ease of calculation, clos- current assets and liabilities that may or not with respect to working capital ing date working capital is often mea- may not be reflected in the most recent (including materiality and conservatism sured at 11:59 p.m. on the day immedi- balance sheet. The parties, together with issues). Although GAAP is often used in ately preceding closing or at 12:01 a.m. their advisors, should work together to some form or fashion as a benchmark, on the closing date. Debt and/or cash, identify the specific assets and liabilities GAAP is not a fixed set of rules. GAAP however, may be measured at a different to include and exclude and determine allows for flexibility, alternative treat- time (e.g., at closing). In such instance, whether any assets or liabilities should ments and the use of discretion. consideration should be given to the be taken into consideration in the target Complications also arise when an interplay between working capital and or the actual working capital but not in acquired business follows GAAP in cash (for which the seller typically gets the other. its year-end accounting but not on an the benefit) when, on the closing date, Calculation Methodologies interim basis, or when such a com- cash is received in respect of a current Purchase agreements often provide pany has never closed its books on asset. Consideration may also need to that closing date working capital will an intra-month basis and the transac- be given to the treatment of outstand- be determined in accordance with gen- tion closes mid-month. How should ing checks, wires and/or ACH payments erally accepted accounting principles GAAP be applied? What does “con- issued by the acquired business but not (GAAP) consistently applied. Such a sistent” mean in such case? Counsel yet cleared or settled. standard, however, may not be suffi- should also consider disregarding cient to ensure an “apples to apples” the impact of the consummation of Types of Adjustments and Procedures comparison of closing date working the transaction at hand, regardless capital to the target and, consequently, of past purchase accounting practic- Working capital adjustments may be may not always be appropriate. Various es. Furthermore, the parties should two-way (i.e., up or down; this is most alternative standards are often used, address how post-signing/pre-closing common) or one-way (only up or only including that closing date working events could affect the calculation of down) or capped, banded, subject to a capital be determined: working capital. Should reserves be basket or dollar-for-dollar (most com- • in accordance with GAAP applied in subject to adjustment as a result of mon). Adjustments also typically take a manner consistent with the methodol- such events or changes (particularly the form of a single-step or two-step ogies and procedures used to determine if such post-signing event is not one process. the latest balance sheet of the acquired for which the target has previously The purchase agreement will typi- business; accounted)? cally provide that the buyer will have MONDAY, oCTOBER 26, 2015

some number of days after closing to delivered closing statement and objec- parties or whether some other procedure, deliver a “closing statement” setting tion notice. The purchase agreement such as baseball style arbitration, must forth its calculation of, among other should also address whether undisputed be used (which, although less common, things, working capital and the compo- amounts should be released from escrow arguably disincentivizes overly aggres- nents thereof. This is common in both or otherwise paid over prior to the final sive positions) should also be specified. a one-step and a two-step process. In resolution of working capital. Exclusivity of Remedy a single step process, the buyer pays Dispute Resolution Given the financial complexity the purchase price on the assumption The purchase agreement should pro- involved, deal parties often prefer that that closing date working capital equals vide detailed procedures for addressing all purchase price adjustment disputes, target working capital and then calcu- purchase price adjustment disputes including whether the proper work- lates closing date working capital after between buyers and sellers. Typically, ing capital calculation methodology closing. In a two-step process, one of there is a period of time (e.g., 30 days) was used, be resolved solely by the the parties—typically the seller—will allotted for the parties to negotiate in neutral and not in a court proceed- deliver an “estimated closing state- good faith. After such period has expired, ing. Accordingly, such intent should ment” shortly before closing, and the it is common for the dispute to be settled be stated in the purchase agreement amount the buyer pays at closing will by a neutral accounting firm. The neutral with precision and M&A counsel should be adjusted accounting for deviations can be named in the purchase agreement carefully consider whether any other from target working capital (as reflected or can be selected pursuant to an agreed provisions, including exclusive remedy in the estimated closing statement). The procedure. In either case, such neutral components of indemnification provi- second step follows the buyer’s delivery will typically be independent and not sions, may allow a judge or arbitrator of the closing statement. In such case, the the accounting firm used by buyer or to decide such dispute. buyer calculates the closing date working seller in the ordinary course. The par- Once the working capital adjustment, capital but compares such calculation ties should also determine whether the if any, is finally determined, the relevant against what was paid at closing and a neutral should function as an indepen- amount will need to be paid to the appli- true-up payment is then made by the dent expert and not as an arbitrator. cable party. The purchase agreement buyer or seller, as applicable. Two-step If deemed an arbitrator, M&A counsel will need to address the timing of such adjustments are prevalent. They reduce needs to determine whether there are payment, the source of such payment the likelihood of large true-up payments, unintended consequences regarding and the rate of interest payable (if any). particularly in scenarios where a signifi- procedure and scope of review, includ- A portion of the purchase price is often cant amount of time passes between sign- ing the implication that the neutral is placed into escrow to serve as a source of ing and closing. Such a mechanism may, to make decisions with respect to legal recovery for purchase price adjustments. however, open the door for gamesman- issues, such as liability. Sometimes only one escrow is provided ship on the part of seller. In light of the The neutral should be required to and payments therefrom serve to reduce foregoing, M&A counsel needs to consider make its determination solely based proceeds available to satisfy indemnifi- the inclusion or absence of review and on the accounting methodologies and cation claims. In other cases, there may comment rights, interest payments, tim- definitions specifically set forth in the be a separate adjustment escrow. Other ing and escrows. purchase agreement and should not possibilities include holdbacks, set-off Review Periods make any determinations with respect rights (particularly if there is an earn-out) Appropriate review periods also need to to matters not in dispute, including any or simply an obligation to pay. Counsel be negotiated. Often the failure to timely independent evaluation of the appro- should consider whether or not such deliver a closing statement will result in priateness of target working capital. arrangements constitute a cap on recov- deemed acceptance of the seller’s position Furthermore, the parties should decide ery and whether the mechanics provide and the failure to timely object will result on the scope of permissible review and an incentive to manipulate working capital in the deemed acceptance of the buyer’s objection. The purchase agreement or estimates. position. Accordingly, the parties need to engagement letter should also address consider such timing implications in nego- whether the neutral will be entitled tiating appropriate review periods and to review the parties’ work papers or ensure appropriate access to records. In request additional information. Wheth- Reprinted with permission from the October 26, 2015 edition of the NEW YORK addition, the purchase agreement should er the neutral must resolve disputed LAW JOURNAL © 2015 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For information, contact 877-257-3382 specify the requirements for a properly items within the range asserted by the or [email protected]. # 070-10-15-34