The Working Capital Adjustment

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In a previous blog post, Busting the Biggest Myth About Selling Your Business, we reviewed a number of fundamental facts related to the sale of any company that warrant being repeated here:

• The single biggest myth about selling a company is that the seller bears no further risk after the sale of her company is completed

• The M&A negotiation process between buyer and seller is effectively a process whereby two parties mutually decide which risks will be borne by whom, and whether any given party will bear an asymmetric share of any given risk

• Buyers have many mechanisms available to them to shift legal and financial risk back onto the seller before, during, and after closing. These mechanisms are very common, and you should expect at least some of them to be part of your own transaction should you decide to sell your company

One mechanism in particular however seems to be the most fraught with confusion, and often presents one of the larger sources of financial risk to the selling entrepreneur. That mechanism is called the working capital adjustment. The rest of this post will be dedicated to discussing why the working capital adjustment is necessary, how it typically works, and common mistakes made by both buyers and sellers that can have material financial impacts.

The working capital adjustment is based on the idea that any valuation ascribed to any business is contingent upon the business having a “normal” balance of working capital (current assets minus current liabilities) on the day of closing. At closing, if the business is delivered to the buyer with “more than normal” working capital, then that positive variance gets added to the purchase price, and paid to the seller. If the business has a “less than normal” balance of working capital at closing, then that variance gets subtracted from the purchase price, and gets paid to the buyer. Typically, this working capital calculation (or “adjustment”) is done anywhere between 30-120 days after closing, which gives both parties enough time to make their own calculations concerning whether or not the business was delivered to the buyer with a “normal” level of working capital. Working capital mechanisms are necessary in most transactions for reasons that include:

• Protecting Buyers: Without a working capital adjustment, sellers would have an opportunity to artificially enrich themselves beyond the agreed upon purchase price immediately prior to the transaction’s closing date. For example, before closing, sellers could choose to collect all of their receivables, delay all of their payables, and/or refuse to buy any new inventory. Any cash collected from receivables, as well as cash not expended in satisfying payables or purchasing inventory, would go straight into the seller’s pocket in this example. If this happened, on closing day the new owner would be left with a business that owes much more than usual, is owed much less than usual, and/or doesn’t have the inventory required to satisfy ordinary course purchase orders. Because the buyer’s valuation assumed that working capital levels were going to be “normal” relative to historical norms, these would represent cash outflows that the buyer would have to bear that were not originally contemplated by them.

• Protecting Sellers: The sale of a company happens at a singular point in time, and sometimes the events that take place immediately before or immediately after a sale are not representative of the steady-state operations of that business. For example, consider a $5M revenue business with a $2M outstanding receivable from its largest customer that has been outstanding for 6 months. This is obviously a very material amount of money for this company. This receivable is based on a sale that the company made 6 months ago, so naturally the seller expects the proceeds to go into her pockets, not those of the acquiror. Without a working capital adjustment, if that customer decided to finally pay their bill even 1 day after the company was sold, then that cash would go into the pockets of the acquiror, not the seller, because all cash flows that occur after closing “belong” to the acquiror, despite when the underlying sale was made. The working capital mechanism exists to adjust for such anomalies.  

In order to prevent things like these from happening, buyers and sellers will negotiate a working capital “peg” (a target) that they mutually agree represents a “normal” level of working capital in the business. Approximately 30-120 days after closing, the actual amount of working capital on the closing date is compared to the peg. If the actual working capital balance exceeds that of the target, then the seller gets that variance paid to them (in effect increasing the purchase price). If actual the working capital balance is less than that of the target, then the buyer gets that variance paid to them (in effect decreasing the purchase price), often via the funds held in escrow.

Though this may sound simple enough, it is through this mechanism that many inexperienced sellers leave money on the table relative to their more experienced and savvy counterparts. As we saw in “Busting the Biggest Myth About Selling Your Business”, receiving a $20M valuation for your company does not necessarily mean that you will collect $20M in cash. There are many ways in which buyers may attempt to utilize the working capital mechanism to effectively reduce their purchase price. When selling your own business, keep your eyes open for the following:

• The Definition of Working Capital Itself: It is almost never as simple as current assets minus current liabilities, despite this being the term’s academic definition. Expect this definition to be heavily negotiated. Remember that, all other things being equal, the buyer would prefer to set the working capital peg high to increase the likelihood that the company is delivered to them with an amount of working capital that is less than the peg, prompting a payment to them, or an effective reduction to purchase price (note of course that buyers will always need to make sure that the business is delivered to them at closing with enough working capital to allow them to smoothly operate the business in the early days and weeks). Keep this in mind when potential acquirors try to include or exclude certain things from the definition of current assets and/or current liabilities.

• The Choice of the “Peg”: Any true-up payment after closing to either buyer or seller depends entirely on the level of working capital at closing relative to the agreed upon peg. You should also expect the peg itself to be heavily negotiated. Is “normal” working capital equal to the average level of working capital over the past 6 months? 12 months? 24 months? If your business is highly seasonal and you’re selling it in November, is a “normal” working capital balance equal to the average balance over each of the past two Novembers? Four Novembers? What happens if the business has grown substantially over that same period, such that the working capital balance in each successive year is materially different from the balance in the prior year? All else being equal, expect your buyer to argue for a definition of “normal” that best suits their own interests.

Once it’s time to negotiate the actual adjustment to the purchase price 30-120 days after closing, you should also recognize that in some instances, the acquiror may find themselves in a bit of an awkward position: On one hand, they may wish to use the working capital adjustment to recoup as much of their purchase price as possible, specifically if money is legitimately owed to them (if money isn’t legitimately owed, that would represent bad faith negotiation, and over time this would ruin the reputation of said acquiror). On the other hand, the reality of many SMB sales is that the buyer tends to be heavily dependent on the seller during the first 1-6 months after closing (particularly if the buyer is an individual entrepreneur, or another small business) related to things like customer relationships, industry knowledge, navigating internal policies and procedures, and so on. It is for this reason that buyers often have to be quite thoughtful about just how aggressive they want to be in these post-close working capital negotiations: Reducing their purchase price might be a good outcome, but not if it comes at the expense of ruining a relationship with a person on whom they will be heavily dependent for the next 1-6 months.

The Importance of Proper Accruals and Closing Adjustments

Often in spite of their best efforts, many SMBs don’t have audited financial statements, don’t make GAAP-compliant monthly accruals and closing adjustments, and lack a robust finance & accounting operation more broadly. Though this is indeed common and in and of itself shouldn’t be a cause for concern, it can present several unique challenges for both buyers and sellers in determining the actual balance of working capital, including when establishing the peg.

It is therefore in the best interests of both buyer and seller to ensure that the working capital balance is stated in a GAAP-compliant manner before the working capital negotiations begin. Though there can be a wide range of areas in which working capital balances can be calculated in a non-GAAP-compliant manner, some of the more common examples in my experience include:

• Properly accruing for things like vacations, bonuses, and sales commissions on a monthly basis (if sellers don’t do this properly, buyers may inherit more financial obligations than the balance sheet would suggest on its surface)
• Properly accruing for deferred revenue balances (the larger the balance, the more material of an issue this will be. This tends to be very common within software companies, and in other companies that have a negative working capital cycle – that is, they get paid by their customers before they fulfill their obligations to them)
• Making allowances for doubtful accounts (contemplated non-payments) when computing their balance of accounts receivable
• Having prepaid expenses that have sat on the balance sheet for too long, and are thus highly unlikely to be used (these artificially inflated balances suggest that a buyer is inheriting more of a financial benefit than they will actually inherit in practice)
• Taxes payable: In many jurisdictions, tax authorities impose a financial penalty for waiting until year-end to pay the company’s taxes owing (the government prefers to receive monthly income tax installments based on the company’s projected tax liability for the year, and does a final reconciliation at the end of the year). For any companies who don’t make these monthly income tax installment payments, they usually don’t properly accrue for the financial penalty that they will have to pay in the following tax year, which usually represents a financial obligation that will have to be borne by buyer, and likely one that they hadn’t originally contemplated.

In Sum

The working capital adjustment is often the risk-sharing mechanism that presents sellers with the largest source of financial risk even after their business is sold. The more educated you are on this mechanism before you try to sell your business, the better prepared you’ll be once this issue is inevitably discussed during the course of your negotiation process.

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