What Does Working Capital Adjustment Mean?
A working capital adjustment occurs when a seller does not deliver the net working capital pegged by the buyer as part of the tangible asset backing required to close a transaction.
When a buyer assesses a target, it will estimate the average net operating working capital (NOWC) required to sustain the current revenue levels. It may then require the seller to deliver a certain net working capital amount in addition to the fair market value of capital assets to support the enterprise value calculated for the business.
The required working capital is usually calculated at letter of intent stage, and further refined during the due diligence process. At closing, if the actual working capital delivered is more or less than that, then usually a dollar for dollar adjustment upwards (if working capital is more than the peg) or downwards (if working capital is less than peg) occurs.
Divestopedia Explains Working Capital Adjustment
Working capital adjustments are very common in M&A transactions. Sellers should understand what their real average NOWC is so as to ensure that a buyer does not overstate the number. Often buyers use a higher working capital peg to justify a downward adjustment to the purchase price.
Sellers must ensure that all their current assets are included in their working capital calculation. For example, some private companies expense all their supplies to get a quicker write-off for tax purposes. However, if working capital is being calculated for purposes of a sale transaction, some of these supplies should be inventoried and form part of current assets. The same applies for prepaid expenses which a private company owner may simply expense throughout the year. These prepaids should also be included.
While working capital adjustments may occur at the closing date, they are more likely to occur 90 to 120 days after closing. This is because the buyer usually requires this much time to have its auditors review the numbers. By then, all accounts are closed and the more accurate working capital number can be calculated. This final number is the one compared to the original working capital threshold, and therefore drives the adjustment. To protect themselves from any major fluctuations in working capital between the closing date and when the numbers are finally audited, buyers usually require a holdback which can be used to make up for any adjustments.