Working capital purchase price adjustments are a part of most M&A merger agreements. This working capital adjustment checklist is meant to be a guide for seller company management teams and their accounting and legal advisors to help them successfully set the net working capital target, negotiate the relevant portion of the acquisition agreement and prepare the estimated (pre-closing) balance sheet of the Company in anticipation of the closing of the M&A deal.
Pre-Closing Negotiation of the Net Working Capital Target
- Typically, working capital is defined as some variation of the current assets less the current liabilities that are required to operate the business in the ordinary course in a twelve-month period.
- Generally speaking, ensure the net working capital target is negotiated and established based on the Company’s normalized / adjusted GAAP accrual-based historical balance sheet over a relevant recent time period (e.g., trailing 12 months). There will be instances where a non-GAAP accounting basis may be more applicable to a certain company and/or to a certain account. We recommend that an exhibit of the agreed upon working capital calculation be attached to the merger agreement or included in the disclosure documents.
- Consistency and precision are key to establishing an appropriate net working capital target. Monthly assets and liabilities should be recorded on an accrual basis and non-recurring extraordinary and non-operational items and seasonality should be analyzed to determine the impact on the Company’s working capital position for the period around the expected closing date. For example, if the buyer is proposing a different accounting treatment on revenue recognition than the seller’s historical method, this likely will impact the working capital calculation (e.g., accounts receivable, deferred revenue). In that case, consideration should be made to re-adjust the working capital target to ensure consistency. An accrual basis generally provides a more consistent and accurate basis for presenting the Company’s financial position.
- For current assets, ensure that the target is not set unreasonably high. For example, recording an aggressively high receivable or inventory balance increases the likelihood that the target is set too high and there will be an unfavorable adjustment later. If uncertain, consider handling AR reserves on a carve-out basis if the status of bad debts may be a controversial matter post-acquisition.
- For current liabilities, ensure that all liabilities are captured and recorded on a monthly basis. Accrued bonuses and commissions, insurance loss reserves, and warranty reserves are the typical disputed items as they may typically only be recorded on a quarterly basis and accordingly set too low.
- Consideration should be taken to normalize / adjust the historical balance sheet on a monthly basis for items that are subject to more judgment in accounting treatment, such as seasonality in the business, mid-month fluctuations, inventory obsolescence, and allowances for doubtful receivables to ensure that their expected impact around the time of the closing is accurately reflected.
- Analyze the potential impact of a mid-month close. Specify whether an accrual or assets are to be amortized based on calendar days vs business days. Accrued payroll and deferred revenue are two of the most disputed items due to large amounts.
- Ensure the components of working capital are specifically stated in the merger agreement and accounts to be included and excluded are identified. Ensure there is no double counting of any kind (an item may be in working capital vs. transaction expenses, but not both).
- Specify the basis of accounting to be applied in calculating the target working capital. For example, US GAAP consistent with the pre-acquisition policies and procedures of the Company.
- Consider performing a systems audit and identify whether all licensing is in place or whether an accrual for additional or corrective licensing should be considered.
- If there are uncertainties in the precision of the working capital and assumptions used in the estimates, consider and negotiate a floor and ceiling on the potential working capital adjustment to limit a downward risk and upside potential to the sellers.
Estimated Closing Statement Preparation and Delivery
Accounting and Legal Resources
- Identify staff and accounting resources that will be willing and able to assist in the post-closing accounting review of the true-up statement subsequently delivered by the buyer.
- Ensure that the acquisition agreement includes a conflict waiver that would allow seller counsel to assist the sellers in the event of a dispute with the buyer.
Recommended pre-closing activities of the seller’s accounting team
- Prepare the estimated closing statement in a similar manner as used in the Company’s monthly or annual close process for setting the working capital target. If the merger agreement specifies that the accounting should be prepared on a consistent basis with year-end reporting, then prepare the estimate with the annual close process and include/document auditor adjustments.
- Record the estimated closing statement on an accrual basis and adjust as appropriate to ensure the consistent application with the adjustment provisions of the merger agreement.
- Account for quarter-end or year-end audit adjustments, seasonal fluctuations, etc. to determine the impact on the Company’s working capital position for the period around the expected closing date.
- Document relevant methodology used for various assumptions and supporting schedules as much as possible.
- Inquire with various departments to identify any contingent liabilities and ensure that they are recorded appropriately. Examples include any applicable unwritten and undocumented commitments and contingencies (e.g. customer contracts, credits and provisions, licensing arrangements, third-party obligations, contractual obligations, etc.).
Information that we suggest be made available to seller counsel and the shareholder representative
- Analysis and supporting workpapers around development of the working capital target, the estimated balance sheet, cash, working capital, debt, transaction expense and other relevant items in the closing certificate.
- Due diligence files / access to data room.
- Documented accounting policies and procedures of the Company and applicable workpapers used by the auditors or communications with the auditors.
- We recommend providing these to seller counsel and to the shareholder representative prior to Closing to avoid any dispute with the buyer as to whether the shareholder representative is entitled to receive such information.
Considerations for Merger Agreement Provisions
- Determine the exact date and time to be used to measure closing statement items (e.g. as of 11:59 pm the day prior to closing) to avoid controversy later about the appropriate measurement date.
- Review all definitional items relevant to the closing certificate to ensure consistency with adjustment provisions of the merger agreement. If the buyer and seller accounting teams agree to specific treatments or adjustments to the Company’s accounting, provide a list of these to counsel to make sure these are properly incorporated into the merger agreement.
- Detailed accounting rules, procedures, and calculations relevant to estimated items in the closing certificate would ideally be attached as an exhibit to the merger agreement. Consider, if applicable, including language that the accounting exhibit has priority over GAAP and the Company’s accounting policies and procedures for purpose of the purchase price adjustment.
- In most agreements, exclude contingent liabilities and tax assets and liabilities from the working capital calculation. These are frequent areas of dispute after closing because the buyer may take a more conservative position than the seller. The parties may consider agreeing to treat them as indemnification claims or carve-outs instead.
- Consider carving out any reserves (such as for doubtful accounts or warranty costs) that require extended timeframes to determine final results. These can often be resolved by giving the parties more time (e.g. 6 to 12 months) so that actual results can be used rather than relying on the assumptions and judgments that the buyer and seller make at the time of closing.
- Review disclosure schedules for any item that may potentially be quantified as a liability or a post-acquisition disputed item. Document any agreement with buyer that these liabilities will not be included in the purchase price adjustment but handled as carved out items or indemnification claims.
- Ensure that claims for liability items are allowed to be made only through either the purchase price adjustment or indemnification claim provisions, but not both (i.e., no “second bite at the apple”).
- If any item assumes performance by a third party immediately prior to closing, the parties should agree in writing to the treatment if the event instead happens shortly after closing. These might include: purchase orders or contracts that are expected before closing, but that come in shortly after closing, cash receipts, lifting of restrictions on cash, etc.
- Consider the source of payment and related logistics of any negative purchase price adjustment. Options include a separate escrow fund, the general escrow fund or recourse directly against the sellers.
- Consider how any post-closing reviews and possible disputes will be handled and who should be included in any relevant communications and decision making and have the applicable parties agree upon the rules of how those issues will be handled.