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Mergers & Acquisitions | MONDAY, OctOber 26, 2015 | S9
Definition of Working Capital
one of the biggest mistakes made in defin- ing working capital is lack of specificity. To avoid inadvertent windfalls and post closing disputes, the parties to a transaction should define working capital precisely. The defini- tion should at a minimum specify the particu- lar accounts (encompassing all components of each included category of current assets and current liabilities, including general led- ger account references) that are included in current assets and current liabilities and should also specify such accounts that are excluded.
Careful attention should also be paid to several items that should possibly be exclud- ed or may be dealt with in other provisions of the purchase agreement. Such items include the treatment of cash and pre-paid expenses as well as the current portion of long-term indebtedness and other debt components (particularly if there are separate purchase price adjustments with respect to such items); bonus accruals; deferred revenue and/or lia-
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 ad- justments can be significant.
bilities; the treatment of income taxes (par- ticularly in the event there is a standalone pre-closing tax indemnity or the seller gets the benefit of income tax refunds); employee liabilities; customer deposits; related party receivables; past due receivables (and the likelihood they will be received); whether the transaction is a carve-out, a stock deal or an asset deal (in which case, excluded assets and liabilities should likely also be excluded from working capital); any need for a physi- cal inventory; and other current assets and liabilities that may or may not be reflected in the most recent balance sheet. The parties, together with their advisors, should work together to identify the specific assets and liabilities to include and exclude and deter- mine whether any assets or liabilities should be taken into consideration in the target or the actual working capital but not in the other.
Calculation Methodologies
Purchase agreements often provide that closing date working capital will be deter- mined in accordance with generally accepted accounting principles (GAAP) consistently applied. Such a standard, however, may not be sufficient to ensure an “apples to apples” comparison of closing date working capital to the target and, consequently, may not always be appropriate. various alternative standards are often used, including that closing date working capital be determined:
• in accordance with GAAP applied in a manner consistent with the methodologies and procedures used to determine the latest balance sheet of the acquired business;
• in accordance with GAAP applied in a manner consistent with the historical prac- tices of the acquired business;
• in accordance with GAAP applied in a manner consistent with the methodologies and procedures used to determine target working capital;
• by subtracting current liabilities from current assets (each as defined by reference to a list of included and excluded general ledger accounts); and
• in accordance with the methodologies, procedures and principles set forth in an exhibit.
The agreed-upon methodology should address instances where the acquired busi- ness’s accounting practices (or certain of them) are not GAAP compliant or where accounting practices are GAAP compliant with respect to financial statements as a whole but not with respect to working capital (including materiality and conservatism issues). Although GAAP is often used in some form or fashion as a benchmark, GAAP is not a fixed set of rules. GAAP allows for flexibility, alternative treatments and the use of discretion.
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Complications also arise when an acquired business follows GAAP in its year- end accounting but not on an interim basis, or when such a company has never closed its books on an intra-month basis and the transaction closes mid-month. how should GAAP be applied? what does “consistent” mean in such case? Counsel should also consider disregarding the impact of the consummation of the transaction at hand, regardless of past purchase accounting practices. Furthermore, the parties should address how post-signing/pre-closing events could affect the calculation of working capi- tal. Should reserves be subject to adjust- ment as a result of such events or changes (particularly if such post-signing event is not one for which the target has previously accounted)?
The parties, consequently, often will be served best by carefully and robustly delineat- ing the methodologies and procedures to be used. In many cases, the same methodologies and procedures that were used to calculate the target working capital should be used in calculating the closing date working capital, with such procedures specified in an exhibit to the purchase agreement. Taking such an approach and providing an illustrative calcu- lation of target working capital—as opposed to merely defining target working capital as a number—will often reduce the likelihood of post-closing disputes, or, in the event of a dispute, provide the party tasked with resolv- ing such dispute less room for independent interpretation and analysis.
Timing implications also need to be con- sidered. For ease of calculation, closing date working capital is often measured at 11:59 p.m. on the day immediately preceding clos- ing or at 12:01 a.m. on the closing date. Debt and/or cash, however, may be measured at a different time (e.g., at closing). In such instance, consideration should be given to the interplay between working capital and cash (for which the seller typically gets the benefit) when, on the closing date, cash is received in respect of a current asset. Consideration may also need to be given to the treatment of outstanding checks, wires and/or » Page S11
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