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M&A: Working Capital Adjustments

Understanding Post-Transaction Net Working Capital Adjustments and the Importance of Proper M&A Counsel

When a business transaction, such as a merger or acquisition (M&A), takes place, one of the key factors that determines the final purchase price is the post-transaction working capital adjustment. This adjustment ensures that the seller delivers a business in a condition that aligns with the agreed-upon terms and that the buyer receives an operating business at the right value. Understanding how these adjustments work, including concepts like “cap and basket,” is essential for both sellers and buyers to navigate the complexities of M&A deals successfully.

What Are Post-Transaction Net Working Capital Adjustments?

Net working capital (NWC) is the difference between a company’s current assets and current liabilities. During the transaction, parties typically agree on a target NWC figure that the business should have at closing. The purpose of a post-transaction working capital adjustment is to reconcile any differences between the agreed-upon target and the actual NWC at the time the deal closes.

The NWC adjustment is a critical part of many M&A agreements. It ensures that the buyer is not overpaying for a business that has an unexpectedly low working capital or underpaying for one that has excessive working capital at closing.

Here’s how it typically works:

1. Target Net Working Capital: The parties agree on a target NWC level at the time of the deal’s negotiation. This is often based on historical trends, such as the average NWC over the past few months or the last year.
2. Closing Balance Sheet: At the closing of the transaction, a final balance sheet is prepared, reflecting the actual NWC on the closing date.
3. Adjustment Mechanism: If the actual NWC differs from the target, the purchase price is adjusted. For example, if the actual NWC is lower than the target, the buyer may reduce the purchase price by the difference. Conversely, if the NWC is higher, the seller may be entitled to an increase in the purchase price.
4. Final Settlement: The buyer and seller will typically agree on a process to resolve the final NWC adjustment, including dispute resolution mechanisms in case the parties disagree over the calculation.

These adjustments are meant to reflect the actual working capital necessary to operate the business and to avoid a situation where either the buyer or the seller is at a disadvantage.

Understanding the “Cap and Basket” Mechanism

In M&A transactions, both buyers and sellers seek to limit their exposure to certain risks, especially regarding post-transaction adjustments. This is where the “cap and basket” mechanism comes into play. It provides a framework to mitigate the potential for excessive price adjustments related to post-transaction working capital discrepancies.

• Basket: A basket defines the minimum amount by which the working capital adjustment must exceed before it can trigger a change in the purchase price. In essence, a basket sets a threshold under which minor discrepancies in working capital won’t lead to a price adjustment. For example, if the basket is set at $500,000, any difference in working capital below this amount would not lead to a price change. The purpose of the basket is to avoid the cost and complexity of adjusting the purchase price for relatively minor discrepancies.
• Cap: The cap, on the other hand, sets a maximum limit on the total amount by which the purchase price can be adjusted due to changes in working capital. This protects the seller from extreme adjustments that could significantly reduce their proceeds from the transaction. For example, if the cap is set at $5 million, the buyer cannot demand a price reduction that exceeds this amount, no matter how much the actual NWC deviates from the target.

Together, these mechanisms create a framework that ensures both parties are protected against minor discrepancies while limiting the seller’s exposure to major adjustments that could be detrimental to the final deal.

Why Sellers Need Proper M&A Counsel and Advisors

The post-transaction NWC adjustment and cap/basket provisions, while vital to ensuring a fair transaction, are only part of the complex landscape of an M&A deal. Sellers must navigate numerous factors that can put their proceeds at risk if not properly handled. To avoid jeopardizing their financial outcomes, sellers should engage the services of experienced M&A counsel and transaction advisors.

Here are some key reasons why having the right advisors is crucial:

1. Negotiating the Terms: Experienced M&A counsel can help sellers negotiate the terms of the deal, ensuring that the target NWC figure is fair and reflective of the business’s true working capital needs. An advisor can also help the seller understand the implications of the cap and basket provisions, protecting them from excessive risks.
2. Valuation Expertise: Proper valuation of the business, including its NWC, requires in-depth knowledge of industry practices and accounting standards. M&A advisors can ensure that the working capital is properly calculated and that the seller isn’t overexposed to unforeseen adjustments.
3. Dispute Resolution: Disagreements between the buyer and seller over the NWC adjustment are common. Having experienced M&A counsel allows the seller to be well-prepared for any disputes that arise and ensures that they have the resources to resolve issues efficiently and fairly.
4. Tax Implications: M&A transactions have significant tax implications that must be carefully structured to minimize tax liabilities. Transaction advisors, including tax specialists, can help the seller avoid unfavorable tax consequences from working capital adjustments and other elements of the deal.
5. Managing the Closing Process: The closing of an M&A deal often involves numerous moving parts, including the finalization of financials, adjustments, and other closing conditions. A skilled advisor can help sellers stay organized and on track to avoid any surprises that could negatively affect their proceeds.

Conclusion

Post-transaction net working capital adjustments are an essential component of many M&A deals, ensuring that the buyer receives the right value for the business they are purchasing. Sellers should be particularly mindful of the cap and basket provisions, which offer a way to limit potential risks from working capital discrepancies. However, without the proper M&A counsel and transaction advisors, sellers risk jeopardizing their deal’s outcome. Hiring experienced professionals who understand the nuances of these adjustments and the broader transaction process is critical to ensuring that the seller can navigate the deal and secure the best possible financial outcome.

Paul Fioravanti, MBA, MPA, CTP, is the CEO & Managing Partner of QORVAL Partners, LLC, a FL-based advisory firm (founded 1996 by Jim Malone, six-time Fortune 100/500 CEO) Qorval is a US-based turnaround, restructuring, business optimization and interim management firm. Fioravanti is a proven turnaround CEO with experience in more than 90 situations in more than 40 industries. He earned his MBA and MPA from the University of Rhode Island and completed advanced post-master’s research in finance and marketing at Bryant University. He is a Certified Turnaround Professional and member of the Turnaround Management Association, the Private Directors Association, Association for Corporate Growth (ACG), Association of Merger & Acquisition Advisors (AM&MA), the American Bankruptcy Institute, and IMCUSA. Copyright 2024, Qorval Partners LLC and/or Paul Fioravanti, MBA, MPA, CTP. All rights reserved. No reproduction or redistribution without permission.

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