When signing the last page of a purchase agreement, the last thing one wants to worry about is the potential for disputes after the transaction closes. Numerous clauses in a purchase agreement could eventually lead to a conflict. However, one of the most common areas for disputes is the post-closing net working capital (NWC) adjustment—the difference between the agreed-upon target net working capital and the actual net working capital at closing. It doesn't matter which side is responsible for the initial calculation; there likely will be at least one account or policy that sparks disagreement between the buyer and seller.
Since many purchase agreements contain arbitration clauses, arbitration typically is the next step in the process if disputed NWC items are unable to be resolved. But arbitration can be costly to both sides, even for the party the arbitrator determines to be “right.” Many working capital disputes can be avoided by including the proper language and exhibits in the purchase agreement.
Purpose of Post-Closing Working Capital Adjustment
We have heard numerous arguments from buyers and sellers regarding the theoretical purpose of the post-closing NWC adjustment, and these differences can lead to disputes not typically addressed in the purchase agreement:
The seller may argue the purpose of a working capital adjustment is to compensate the buyer or seller for changes in working capital from the historical (target) period to the closing date. If the company experiences a decrease in profitability during this period that leads to a decrease in working capital, the buyer would be compensated with a decrease in the total purchase price. On the other hand, the seller would benefit for generating increased working capital through the closing date, as any increases would lead to an increased purchase price through the working capital mechanism. In this scenario, the seller may expect the closing working capital calculation to be completed consistent with the target working capital calculation.
On the other hand, the buyer could argue that in addition to a particular earnings level, the purchase price is based on the specific working capital necessary to support that level of earnings. The buyer expects to convert the seller’s working capital into cash within one operating cycle. If any potential departures from generally accepted accounting principles (GAAP) come to light after closing that would decrease closing working capital, the buyer may argue it should be compensated for working capital that is lower than the target. For instance, if a previously unrecorded inventory reserve is deemed necessary, the buyer could argue the purchase price should be reduced since this inventory cannot be converted into cash. In this scenario, the buyer would not be concerned the closing working capital calculation is inconsistent with the target working capital calculation, as its objective would be to protect its future cash flow.
In either case, the buyer is protected from the seller operating the business in a way that differs from historical practice. For instance, if the company offers extra discounts to encourage customers to pay more quickly or allows payables to age longer than normal, the seller could take extra cash at closing. However, the seller will be penalized for delivering lower than expected working capital, offsetting the extra cash taken out of the business and protecting the buyer’s investment in the company.
Does Consistency Trump GAAP?
One provision to watch for in your purchase agreements is the dreaded comma—the provision requiring closing working capital to be prepared in accordance with GAAP, consistent with the company’s past practices. However, when the company’s historical practice differs from GAAP or an alternative GAAP approach is proposed, precedence is not always clear. Here are possible positions that could lead to conflict:
Seller – Historical Practice Prevails: Since the NWC target typically is established using the historical accounting practices, the seller often will argue closing working capital should be computed under the same methodology to be fair to both parties. For instance, if all prepaid expenses are recorded as current assets regardless of the time period in which they are expected to be realized, the seller would argue against reclassifying a portion of these items to noncurrent assets. Such a reclassification would be inconsistent with the target calculation and thus argued as an unfair adjustment.
Buyer – GAAP Prevails: The buyer often will counter the seller’s argument of consistency with a “fairness” argument of its own. Transactions usually are valued based on several factors, such as historical earnings, whether cash or debt will be included in the transaction and what level of NWC or net assets will be acquired. The buyer argues the valuation outlined in the purchase agreement is based on a number of assumptions, including a certain level of working capital to be delivered at closing. This working capital is computed based on GAAP, regardless of accounting practices historically used by the company. As discussed above, the buyer in a transaction expects to convert working capital at closing into cash within the operating cycle of the seller. Reductions in working capital impede this conversion and could require the buyer to infuse the target with additional cash after closing.
Regardless of your chosen position, it is recommended you draft a purchase agreement that is clear on whether closing working capital will be calculated in accordance with GAAP or past practices, but not both. Simple clarification of this clause in the agreement could save a number of arguments.
Specific Areas of Concern
While the argument of GAAP versus past practice frequently accompanies working capital disputes, several other areas should be considered when drafting the purchase agreement:
Accounts with multiple GAAP applications: Even if the purchase agreement clearly states the closing balance sheet be prepared in accordance with GAAP, what constitutes GAAP could still be questioned for accounts requiring significant management judgment—particularly accounting estimates. Reserve accounts such as an allowance for doubtful accounts or inventory obsolescence reserve, and estimates such as discretionary bonus accruals, can have multiple calculations that would be in accordance with GAAP. In the purchase agreement, specific language should be included regarding these accounts where possible. For instance, a specific methodology can be established for the allowance for doubtful accounts based on the accounts receivable aging, or a specific bonus accrual can be agreed on prior to closing the transaction. Since these often are areas of contention between the two parties, agreeing on how they will be handled prior to the transaction can reduce potential disputes after closing.
Normalizing nonrecurring trends: If any nonrecurring trends are identified during the due diligence process, consider adjusting the working capital target for these items. For instance, if the company wrote off a large portion of unreserved inventory six months prior to closing, a pro forma adjustment could be made to the historical inventory balances used in the target calculation. Alternatively, if cash flow issues cause a temporary increase in accounts payable, the target could be adjusted based on normal accounts payable levels. If any normalizing adjustments are included in the working capital target, be sure to include language regarding the treatment of these adjustments at closing.
Accounts to be included in working capital: There also can be disputes regarding exactly what trial balance accounts are included in working capital. To alleviate the risk of disagreements regarding the accounts to be included, consider including an exhibit in the purchase price illustrating the exact trial balance accounts that will be included in the working capital computation.
Pro forma calculation: In order to clearly state the methodology to be used in the working capital adjustment, consider including an example or pro forma calculation in the purchase agreement. The calculation would illustrate how the purchase price will be adjusted at closing (if applicable) as well as the final working capital adjustment.
Avoiding working capital disputes is not easy, as it takes extra time and effort to resolve the issues discussed during the negotiation of the purchase agreement. With so many issues that need to be addressed during the negotiations, parties may prioritize other aspects of the transaction and assume the working capital adjustment will be handled post-closing. This can be a recipe for disaster. Consideration of the aforementioned suggestions may reduce the potential for costly disputes after transaction close, so buyers and sellers can focus on a smooth transition period.
This article is for general information purposes only and is not to be considered as legal advice. This information was written by qualified, experienced BKD professionals, but applying this information to your particular situation requires careful consideration of your specific facts and circumstances. Consult your BKD advisor or legal counsel before acting on any matter covered in this update.
Article reprinted with permission from BKD, LLP, bkd.com. All rights reserved.