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Assessing a company’s working capital is an essential part of merger and acquisition (M&A) transactions. A detailed financial assessment should be performed to determine the financial and legal expectations of both parties involved in the transaction. Working capital adjustments in mergers and acquisitions are essential in situations where the working capital of the acquiree has changed before the transaction is finalized. These adjustments are often used as the basis for changing the originally agreed purchase price.
What is working capital?
When a potential buyer is considering an M&A transaction, they will estimate the average net operating working capital (NOWC) needed to sustain the current revenue earned by the business. In many of these transactions, the buyer will require the business to provide a designated net working capital amount as well as the fair market value of the business’ fixed assets to support the overall enterprise value calculated for the business.
In simpler terms, the NYU Stern School of Business defines a company’s working capital as the difference between current assets (such as cash, accounts receivable, unpaid customer bills, etc.) and current liabilities. . This number measures a company’s liquidity, operational efficiency and short-term financial health. Companies with positive working capital often have significant potential for growth and investment. Conversely, a company whose liabilities exceed its assets (negative working capital) is more likely to struggle to grow or repay its creditors and risks bankruptcy.
What is a working capital adjustment?
A working capital adjustment is a purchase price adjustment based on the working capital of the business or the target business in connection with a merger and/or acquisition. Generally, businesses need a minimum amount of working capital to continue their activities. The party acquiring the target company must ensure that the target company has sufficient working capital after closing to continue its operations. When working capital is insufficient, the buyer may need to invest additional cash in the business, which increases the effective purchase price. To account for this increase, the buyer may require a working capital adjustment, which lowers the purchase price if the target company’s working capital is below a certain level on the closing date.
For working capital adjustments in mergers and acquisitions, both parties will agree on a working capital target that the acquired company should have at the time of closing. Shortly before closing, the seller will provide an estimate of the amount of working capital it expects the target company to have at closing. If the seller’s estimate is greater than the working capital target, the purchase price will be increased by this excess. If the estimate is less than the working capital target, the buyer will receive the difference as a reduction in the purchase price. After closing, the buyer will calculate the amount of working capital the target company had at closing. If the buyer’s calculation differs from the seller’s estimate, the purchase price will be adjusted.
When is working capital calculated?
The required working capital figure is usually calculated during the letter of intent stage of the deal process. In many of these transactions, the letter of intent is one of the first documents discussed between the two parties. It functions as a written record of the parties’ intention to reach an agreement and a summary of all the material terms of the potential agreement.
The Letter of Intent is primarily a starting point for this process, and it is not legally binding. This document helps to outline the main terms of the agreement and to ensure that there are no potential obstacles for either party. However, extensive research and negotiations usually take place for a long time after the letter of intent is written. This part of the process is known as “due diligence”, and the working capital figure can be redefined at this point.
When do working capital adjustments take place?
A working capital adjustment can be made at different times during the trading and transaction process. Although they may occur on the closing date, they generally occur between 90 and 120 days after closing. This delay gives the buyer’s auditors sufficient time to review the calculations. At this point, all accounts are closed, allowing the buyer’s team to calculate a more accurate working capital figure. This final figure is compared to the initial working capital estimate, and any adjustments are based on the differences between these two figures.
Working Capital Adjustment Considerations for Sellers
The owner of the business for sale in an M&A transaction should ensure that he understands how his working capital estimate was calculated. Additionally, knowing the true average net operating working capital (NOWC) needed to maintain current levels of revenue is essential. Sellers should also be aware that buyers may attempt to overestimate this number as a tactic to justify a downward working capital adjustment prior to closing.
Finally, sellers should be sure to include all current assets in their working capital calculations. This may include certain expenses that have been written off for tax savings. In an M&A transaction, some of these expenses and supplies, as well as prepaid expenses, must be reclassified as inventory and included in current assets.
Originally published August 23, 2022
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.
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