Page 8 - M&A

S8 | MONDAY, OctOber 26, 2015 | Mergers & Acquisitions | nylj.com
Working Capital Adjustments:
At the Crossroads of Law and Accounting
By Mark THierFelder, CHriSTian MaTareSe, anTHony CaPorrino
and JonaTHan VanderVeen
W orking capital adjustments are often some of the most highly negotiated provisions in a private company M&A
transaction agreement. The provisions are complex and involve a blend of legal and accounting concepts and standards and can have an immediate impact. It is essential that deal team members understand not only the nuts and bolts of working capital adjustments but also the nuances thereof to avoid traps for the unwary. M&A lawyers must be flu-
Mark THierFelder is a partner and CHriSTian MaTareSe is an associate at Dechert in New York. anTHony CaPorrino and JonaTHan VanderVeen are managing directors with Alvarez & Marsal.
ent with the constituent elements of working capital in a particular business in order to properly understand their client’s business objectives and to properly document the business agreement.
working capital is often crucial to the oper- ation of a business and can significantly affect valuation. Buyers often bid on an acquisi- tion on a cash free, debt free basis, assuming an amount of working capital sufficient to operate the business at closing. The devil, however, is very much in the details.
This article will explore the various issues M&A counsel will face when drafting and negotiating working capital adjustments and highlight several potential “problem areas.”
What Are the Parties Trying to Achieve?
Buyers typically want to protect against the depletion of working capital after signing and ensure that an acquired business has an appropriate amount of working capital.
Adding additional working capital at closing will effectively serve to increase purchase price. Buyers also do not want to discourage sellers from operating in the best interest of the business. For example, buyers do not want the “cash free” nature of a transaction to provide a perverse incentive to discontinue making budgeted capital expenditures. Sellers want to preserve cash and reap the benefits of earnings sellers generated. As a result, the vast majority of M&A transactions include purchase price adjustment for changes in working capital measured against a target.
Components of Working Capital And Calculation Methodologies
A working capital adjustment is essentially a provision that tests closing date working capi- tal against a negotiated benchmark or target working capital. The target is set at signing and actual working capital is determined after clos-
ing. If working capital is higher or lower than the negotiated benchmark, the purchase price is typically adjusted accordingly. This sounds straightforward; however, the components of working capital and the details of the adjust- ment and related dispute resolution mechan- ics often require a thorough understanding of the business. These provisions require not only a keen legal eye but also accounting acu- men. Furthermore, when disputes arise, they are often resolved by accounting experts as opposed to judges. Accordingly, deal teams would be wise to involve both legal counsel experienced in such matters and accounting advisors from the outset.
At its core, working capital is the difference between current assets and current liabilities. This, however, is the first trap for the unwary. The financial impact of the working capital and other purchase price adjustments can be significant. The definitions and method- ologies used must be precise and work with potentially overlapping provisions, such as adjustments for debt, cash and seller trans- action expenses.
Target
Before the parties negotiate the compo- nents of working capital and calculation meth- odologies, they need to agree upon a target working capital. Setting the target based on a specific historical date or set of financial statements is not necessarily appropriate. Ideally, the specifics of the acquired business and relevant facts should be taken into con- sideration before agreeing to a target. Target working capital may be influenced by many things, including anticipated timing between signing and closing, expected closing date and the industry in which the acquired business operates. other key factors to consider in establishing a target include, among others, whether the acquired business:
• experiences seasonal shifts in working capital;
• experiences erratic changes in working capital or operates in a commodity driven business where commodity valuations may be subject to unpredictable swings; and
• is experiencing significant growth or, as a result of receiving payment prior to the delivery of product or services, operates with negative working capital.
A one size fits all approach does not work. Proper financial due diligence is key to avoiding pitfalls. The relative importance of working capital to purchase price should be a guide to the level of diligence and negotia- tion the parties believe is necessary. Among other things, working capital due diligence can uncover trouble spots including under- stated reserves, lack of sufficient reserves, or missing accruals (such as warranty, medical claims, vacations and bonuses), all of which result in higher EBITDA calculations, a mul- tiple of which is often paid as purchase price consideration.
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