Sometimes facts relevant to the proper preparation of financial statements are not known at closing or even during the 90-120 days following closing when the final closing balance sheet is due and working capital adjustments are to be finalized. In other deals, the parties may have believed an issue presented on the estimated closing balance sheet to be final and specifically excluded items from the definition of net working capital, only to find out later that an unexpected event caused the previously dormant issue to regain relevance. While the indemnification provisions of the merger agreement usually protect the buyer in these circumstances over an extended period of time if the unexpected adjustment works against it, the working capital adjustment mechanism is typically the only time when sellers can receive the benefit of new knowledge or an unexpected adjustment in their favor. Therefore, it is important that sellers pay particular attention to exclusions to be applied to the definition of net working capital.
Net working capital is intended to represent those assets and liabilities that are expected to have a short-term impact on cash and equity. The classic definition of net working capital is current assets minus current liabilities. Current assets are generally those that are expected to generate cash within twelve months. Current liabilities are generally those that are expected to use cash within the same timeframe. While it is often appropriate to exclude non-cash items, such as deferred tax assets and liabilities or depreciation, from the definition of working capital, cash is one item that we believe should rarely be excluded from the definition. This is because there is a natural interplay between cash and other items on the balance sheet that might be subject to change through a purchase price adjustment. For example, the collection of accounts receivable will increase cash and reduce the receivables account on the balance sheet.
From time to time we have seen separate procedures for determining the amount of cash and net working capital (exclusive of cash) as of the closing date. In some cases, the true-up process only applies to net working capital and not cash. So, for example, when the buyer presents the final closing balance sheet, accounts receivable could be adjusted downward resulting in a true-up payment to the buyer even though the buyer has already received the cash (when the customer made the payment in question).
Best practice is to ensure that cash is included in the definition of net working capital so that the benefit of a true-up can flow to either party. If the parties do decide to separate the methods and procedures of determining cash and non-cash current items, ensure that the adjustment methodologies are consistent and that the natural interplay between accounts on the balance sheet is recognized in any true-up formulation. Otherwise, someone may receive an unanticipated windfall.