M&A & exit
Working capital adjustment
Closing-date adjustment to purchase price based on actual net working capital vs. agreed target.
Definition
A working capital adjustment is a closing-date mechanism that adjusts the M&A purchase price based on the actual net working capital of the target business at closing, compared to an agreed target. The adjustment protects the buyer from a target that has drained working capital pre-close (e.g., collecting receivables but not paying payables) and ensures the seller is paid based on a normalized working capital position. Calculated on the closing balance sheet, usually finalized 60-90 days post-close.
Same concept, different references
| Canada (common law) | Working capital adjustment, contractual (SPA) |
|---|---|
| Quebec (Civil Code) | Ajustement du fonds de roulement, art. 1373+ CCQ on sale price |
| US (UCC, state law) | Working capital adjustment, governed by SPA |
| Accounting | GAAP or IFRS basis, as specified in the SPA |
How the adjustment works
The mechanics of a working capital adjustment unfold in several stages:
- Target NWC: at SPA signing, parties agree on a 'target' net working capital — usually based on average NWC over the last 12 months
- Estimated closing NWC: seller delivers an estimated closing balance sheet a few days before closing. Initial purchase price adjustment based on estimate vs target
- Closing: purchase price adjusted by estimated NWC vs target — increase if NWC > target, decrease if NWC < target
- Final closing balance sheet: seller (sometimes buyer) prepares the actual closing balance sheet within 60-90 days post-close
- True-up: any difference between estimated and actual is paid (or returned) between the parties. Disputed items go to an independent accountant
Defining 'net working capital'
The definition of NWC is one of the most heavily negotiated SPA provisions:
- Standard definition: current assets minus current liabilities, excluding cash and cash equivalents and excluding debt
- Excluded items: cash (treated as separate adjustment), debt (treated as separate adjustment), certain accrued items (e.g., transaction expenses)
- GAAP vs IFRS basis: must be specified; affects how items like deferred revenue and accrued liabilities are calculated
- Consistency requirement: closing NWC must be calculated 'consistent with' the methodology used in agreed historical balance sheets
Common disputes
Working capital adjustments are among the most litigated post-close M&A issues:
- Methodology disputes: did the closing balance sheet apply consistent accounting principles?
- Accrual disputes: appropriate level of accruals for warranty, returns, bad debts
- One-time items: should transaction-related expenses or windfall items be included or excluded?
- Disputed receivables: appropriate reserves for bad debts or disputed customer accounts
In Octelligence
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