A working capital adjustment is a type of purchase price adjustment seen in the acquisition of a business.
A buyer would demand a working capital adjustment to ensure the business has enough working capital post-closing to continue operations previously conducted by the seller.
Not enough working capital means a liquidity problem and the buyer needs to inject more cash into the business to meet the minimum amount of working capital, effectively increasing the purchase price.
What is working capital?
Working capital is a balance sheet metric that represents the operating liquidity available to a business. It's calculated as current assets minus current liabilities.
Here are examples of the most common working capital items necessary for the day-to-day business operations:
Current assets
Accounts receivable
Inventory
Prepaid expenses
Current liabilities
Accounts payable
Accrued expenses
Deferred revenue or prepayments received
Working capital measures the company's liquidity and operational efficiency.
A positive working capital indicates the company has enough assets to cover its short-term liabilities. However, an excess working capital in unsold inventory or uncollected receivables from previous sales suggests operational inefficiencies.
A negative working capital signifies a potential liquidity problem, meaning the company may struggle to meet its short-term obligations.
Why does a buyer want a working capital adjustment?
Companies need a minimum amount of working capital to maintain their operations. However, working capital constantly fluctuates.
A buyer acquiring a target company needs to ensure it has sufficient working capital post-closing to continue operations previously conducted by the seller. They don't want insufficient working capital, which means a liquidity problem.
Most businesses need a minimum amount of working capital. Not having enough working capital requires the buyer to invest more cash into the business, increasing the purchase price.
A working capital adjustment protects the buyer.
Suppose the seller goes below the minimum amount of working capital before closing. In that case, a working capital adjustment is made, which lowers the purchase price and maintains the minimum amount of working capital in the target company.
How are working capital adjustments calculated?
A buyer will review the financial statements and look at the average working capital of the target company during the due diligence process. Based on this information, they will ask the seller to provide a certain amount of working capital to maintain business operations.
Both parties need to agree on a target working capital that the acquired company should have at the time of closing.
Shortly before closing, the seller will provide a working capital estimate the target company should have at closing. The difference between the estimated information and the actual working capital is key.
If the seller's estimate exceeds the working capital target, the purchase price will be increased based on the surplus amount.
If the seller's estimate is lower than the working capital target, the purchase price will be reduced by the difference.
When are working capital adjustments settled?
Working capital adjustments typically take place between 90 and 120 days after closing. This time frame can vary and depends on the negotiated payment terms.
The buyer needs to review the estimated information and the financial statements. This will likely happen around three to four months after closing because the financial statements need to be drafted by the target company.
After all the accounts are closed, the actual working capital can be determined. A comparison between The differences between the final amount and estimated information is calculated and the final post-closing adjustment is made.
Is working capital adjustment common in a transaction process?
Working capital adjustments happen regularly in M&A transactions. It's part of the negotiation process and working capital adjustments vary from case to case.
As a seller, it's essential to know the level of working capital needed to sustain current operations ahead of the negotiation.
Sellers should be careful. Buyers will try to come up with various points to overestimate this figure to receive a purchase price adjustment in their favor.
How sellers can profit from a working capital adjustment
Working capital adjustments can work in favor of the seller if carefully negotiated.
Sellers need to prepare a reliable working capital estimate ahead of time to be well-prepared for due diligence. Ensure all current assets are included and all current liabilities are explained when calculating working capital.
The estimated information will be the basis for the purchase price adjustments on the closing date.
If the closing date working capital surges unexpectedly due to more sales and accounts receivable, the seller should receive a purchase price adjustment in their favor.
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