As reported in our last Fortis Insight, the purchase price in a private M&A transaction usually is adjusted based on the target company’s estimated working capital as of the closing date. This gives the sellers the benefit of assets such as cash and receivables, but nets out debt, payables and other liabilities. The parties then go through a working capital adjustment process after closing to finalize the closing date numbers, with any change from the estimated working capital serving as an adjustment to the final purchase price. Based on data that we have collected from over 500 M&A deals where we have served as the post-closing shareholder representative, 64% of such deals include a post-closing adjustment provision to finalize the working capital (see our Forsite™ M&A Deal Tool:
Drafting working capital adjustment provisions raise a number of issues where careful drafting can protect the rights of parties while minimizing the possibility of post-closing disputes.
1. Required vs. Permissive Adjustments
Typically at closing the seller develops an estimated working capital statement for the acquired company. The purchase price for the acquired company is calculated at closing based on that estimated working capital statement. Post-closing, the buyer has an opportunity to review and analyze the estimated statement, aided by the fact that the buyer has now taken over operations and can reconcile the accounts. One important issue is whether the post-closing analysis of the working capital statement is a required process or permissive process. If the process is permissive, then if the buyer discovers that the pre-closing working capital statement underestimated the working capital, the buyer can decline to pursue the matter further, treating the estimated statement as the final statement. Sellers are better served if the post-closing process is required, allowing the sellers to benefit from any increase in working capital discovered post-closing.
2. Standard for Preparation of the Statement
The merger agreement should detail the standard by which the working capital statement should be prepared, whether consistent with the selling company’s past practices, GAAP or some combination of those two standards. The seller should consider attaching a schedule to the merger agreement detailing the standards by which the working capital statement should be prepared, specifically detailing departures from GAAP. For example, the seller may accrue liabilities when an invoice is received rather than when the liability was incurred. If the seller believes the working capital statement should be prepared in accordance with that standard, the standard should be specifically identified in a schedule. Additionally, the merger agreement should state which accounting standard will prevail if there is a conflict.
3. Materiality Collars
The possibility of post-closing arguments over the calculation of working capital can be minimized by setting up collars for the working capital. For example, the merger agreement may provide that no post-closing adjustment will be made unless the final working capital varies from the estimated working capital by a specified amount (either positive or negative), with the specified amount being an amount material to the transaction.
4. Access to Information and Personnel
Once the buyer has calculated the post-closing working capital, the sellers need access to information to verify the buyer’s calculations. While most merger agreements provide that the buyer must supply to the sellers back up worksheets to support the calculations, the more important information may come from the selling company’s former finance personnel, who now may be working for the buyer. The sellers may consider specifying in the merger agreement the names or titles of buyer or former seller personnel whom the buyer must make available to assist the sellers in analyzing the post-closing working capital statement.
These are only a few of the matters buyers and sellers should consider in drafting working capital adjustment provisions. Please contact us if you would like to discuss this issue or any other post-closing matter in connection with M&A transactions. As a leading post-closing shareholder representative on private M&A deals, we have collected data on hundreds of M&A agreements. We have used that data to build a reference tool for the M&A community to empower dealmakers with the data they need to understand “market,” negotiate better deals and follow emerging trends. You can explore further in Fortis Advisors’ Forsite™ M&A Deal Tool. For additional insights into the data, along with practice tips on M&A transactions, you can read further in our After Closing Series, Fortis Insights and Case Studies.