In most of the M&A deals that I am involved in, working capital is one of the most complicated areas to navigate when trying to close a transaction. Here are the areas that you need to consider when thinking about working capital in the context of completing a deal:
Inclusion of Working Capital
First off, let me start by clearing up confusion that some business owners may have regarding the inclusion of working capital in the purchase of a business. When the enterprise value of a business is determined through negotiations between a buyer and a seller, the expectation is that this agreed upon price will include all assets required for the continued operation of the business, including a reasonable level of working capital.
I have experienced some business owners returning to the negotiating table and insisting that working capital should be added to the already-negotiated purchase price. This is not how enterprise value is calculated, and usually results in an infuriated buyer and a failed deal.
Amount of Working Capital
Let’s all agree that a certain amount of working capital must be left in the business when it is sold. The actual amount of working capital that should remain is yet another conversation altogether. These two articles provide an excellent framework for determining an appropriate amount of working capital to be included in an M&A transaction:
Determining Benchmark Working Capital in a Business Acquisition
Negotiating Working Capital Levels in a Business Sale
It important to note that the determination of the appropriate amount of working capital should be forecasted to the closing date. This is especially difficult in seasonal or growing businesses. Vendors and purchasers should also consider if renegotiation of working capital levels is appropriate when the closing date of a transaction is delayed.
Definition of Working Capital
The definition of working capital will be outlined in the purchase agreement, but it is often open to interpretation. Here is a sample working capital definition, provided by my friend, Sarat Maharaj, Partner at Dentons LPP.
“Closing Working Capital” means, at the closing time, the amount equal to:
- all current assets to the extent each such item is considered to be a “Current Asset” in accordance with [insert accepted accounting principal] and including, without duplication, all of the accounts listed in Exhibit “1” hereto, such as cash, accounts receivable (where “accounts receivable” shall include, without duplication, all grants receivable, inventory, work-in progress and prepaids and deposits, but excluding deferred tax assets and any refunds, credits or abatements of Tax); LESS
- all current liabilities to the extent such an item is considered to be a “Current Liability” in accordance with [insert accepted accounting principal] and including, without duplication, all of the accounts listed in Exhibit “1”, including accounts payable and accrued liabilities and Closing Tax Liabilities.
A couple of items to consider with this definition of working capital:
I really like the use of an “exhibit” to provide a clear example of the accounts to be included or excluded in the calculation of working capital. This helps prevent future disputes.
I believe the calculation of working capital included in a transaction should be consistent with historical reporting practices, regardless of guidance from accepted accounting practices. This is especially relevant when a prospective buyer has negotiated appropriate working capital levels based on review of historical financial statements, but newly adopted accounting principals will significantly change the working capital at closing. An example of this might be adopting a new revenue recognition policy from completed contract method to a percentage of completion.
Adjustments to Working Capital
There is no way to accurately forecast working capital at closing with 100% certainty. For this reason, a working capital adjustment is a common mechanism that is used in M&A transactions to true-up the difference between the negotiated amount of working capital (sometimes called closing target or pegged working capital) and the actual amount of working capital at closing. Common wording in a purchase agreement might be as follows:
“If the Closing Working Capital exceeds the Closing Target on the Closing Date, the excess, on a dollar-for-dollar basis, shall be an increase to the purchase price of the Purchased Shares on Closing.
If the Closing Target exceeds the Closing Working Capital on the Closing Date, the excess, on a dollar-for-dollar basis, shall be a decrease to the purchase price of the Purchased Shares on Closing.
If there is a Purchase Price Adjustment Surplus, the Purchaser shall, within 10 days of the date of the Final Closing Working Capital Statement Date, pay the amount of such Purchase Price Adjustment Surplus to the Seller, by way of certified cheque, electronic funds transfer or wire transfer of immediately available funds directly into a bank account designated by such Seller for release to such Seller.
If there is a Purchase Price Adjustment Deficit, the Seller shall, within 10 days of the date of the Final Closing Working Capital Statement Date, pay the amount of such Purchase Price Adjustment Deficit to the Purchaser, by way of certified cheque, electronic funds transfer or wire transfer of immediately available funds directly into a bank account designated by such Purchaser for release to such Purchaser.”
Items to consider with adjustments to working capital:
Before closing the transaction, the seller should try to ensure the working capital is as close to the pegged working capital as possible. A significant purchase price adjustment surplus will mean that the seller will not receive a portion of the purchase price until the closing working capital statement is completed. This could be three to four months after the transaction. There is a risk that the purchaser uses the excess working capital post-closing for other corporate initiative and will not have the money to pay the purchase price adjustment when it is due.
On the other hand, a significant purchase price adjustment deficit could be detrimental to the purchaser in the continued operations of the business and may impact the business’ ability to continue as a going concern.
In some instances, a set-off may be negotiated whereby any surplus/deficit is added/deducted from vendor financing amount. In my opinion, I don’t like setting off purchase price adjustments against other negotiated amounts as it may alter the spirit of the negotiated deal structure.
Reporting and Dispute Resolution of Working Capital
It usually takes some time after the transaction is closed for the external accountants to prepare a financial statement used to determine the actual amount of working capital at the closing date. Here is an example a typical time line, process and dispute resolution mechanism that will be followed:
“No later than 90 days after the Closing Date, the Purchaser shall deliver to the Seller a statement (the “Closing Statement”) setting forth the calculation of the Closing Working Capital of the Corporation, together with reasonable supporting documentation.
The Seller shall, within 30 days following receipt of the Closing Statement, deliver to the Purchaser
- a written notice (the “Notice of Objection”) signed by the Seller, objecting to the Closing Statement setting out in reasonable detail the basis for such objection; or
- a written notice (the “Notice of Approval”) signed by the Seller, approving the Closing Statement, in which case the Closing Statement (and the calculations of the Closing Working Capital of the Corporation) will be final and binding, effective as of the date of such written notice.
If the Purchaser has not received a Notice of Objection or Notice of Approval within such 30 day period, the Seller shall be deemed to have sent a Notice of Approval and the Closing Statement (and the calculations of the Closing Working Capital of the Corporation) will be final and binding effective as of the date of the expiration of said period.
If the Seller delivers a Notice of Objection, the Purchaser and the Seller shall negotiate in good faith and attempt to resolve the matters in dispute. If such negotiations resolve all of the matters in dispute within 15 Business Days following delivery of the Notice of Objection to the Purchaser, the Closing Statement (after giving effect to any adjustments to be made in accordance with such resolution) shall be final and binding, effective as of the date such matters were resolved.
If the negotiations described above fail to resolve all of the matters in dispute within said 15 Business Days following delivery of the Notice of Objection to the Purchaser, then the Seller and the Purchaser shall submit the unresolved portion of the disputed matters (the “Unresolved Matters”) in writing with reasonable particulars to [nationally recognized accounting firm] as may be approved by the Seller and the Purchaser (the “Independent Accounting Firm”), acting reasonably, and the Independent Accounting Firm shall render its opinion as to the Unresolved Matters as an expert and not an arbitrator. Based on such opinion, the Independent Accounting Firm will then send to the Seller and the Purchaser within 30 days of submission of all facts applicable to the Unresolved Matters, the determination of the Independent Accounting Firm on the Unresolved Matters and any adjustments to be made to the Closing Statement. With respect to any Unresolved Matter, the Independent Accounting Firm’s determination shall be no greater than the higher amount calculated by the Seller or the Purchaser, as the case may be, and no less than the lower amount calculated by the Seller or the Purchaser, as the case may be. On receipt of such determination by the Seller and the Purchaser, the Closing Statement (after giving effect to any adjustments to be made in accordance with such determination) shall be final and binding effective as of the date of receipt of such determination. The fees and expenses of the Independent Accounting Firm shall be allocated to be paid by the Purchaser, on the one hand, and/or the Seller, on the other hand, based on the principle that the party prevailing in the majority of the Unresolved Matters bears a lesser amount of such fees and expenses.”
From start to finish, the above process can take five and half months to resolve. Having clarity on the calculation and approximate the amount of closing working capital prior to completion of the transaction can reduce the timeframe and cost associated with determining the purchase price adjustment.
Conclusion
Understanding the above aspects of negotiating working capital will help a vendor navigate one of the most complicated areas of selling a business. While your definition of working capital may differ from the above, based on the nature of your business, it is vital you decide how to calculate your working capital before you enter into negotiations.
Special thanks to Sarat Mahraj, Partner at Denton LLP, for providing the sample wording of working capital clauses in purchase and sale agreements. Sarat’s practice includes providing advice to clients on mergers, acquisitions and sale transactions, including reorganizations and amalgamations. He assists both public and private issuers in raising capital through private placements and with their respective disclosure and reporting requirements. Sarat also advises clients on various corporate and commercial issues such as corporate governance, securities, corporate finance and the organization of new business ventures.