M&A Vocabulary – Explained by the experts: Working Capital Adjustment

In this ongoing series, a number of different M&A experts from the global offices of Rödl & Partner each present an important term from the English specialist language of the mergers and acquisitions world, combined with some comments on how it is used. We are not attempting to provide expert legal precision, review linguistic nuances or present an exhaustive definition, but rather to give a basic understanding or refresher of a term and some useful tips from our consultancy practice.

In a classic company acquisition, the target company is viewed as a system designed to produce profits. The presence of working capital is an essential prerequisite for the good functioning of this system. Working capital consists – to put it simply – of the assets (inventories of goods, receivables, etc.) that are involved in the operational cycle.

For a company acquisition, it is assumed that under the existing circumstances, there exists at all times a natural or typical level of working capital for the target company that is just adequate to maintain day-to-day business activities. The purchase price is defined under the premise that the target company has the necessary – but no excessive – working capital. However, if the actual amount of working capital available at a reference date differs either above or below from this necessary or adequate level, this needs to be handled through the determination of an adjustment mechanism for the calculation of the purchase price (a so-called “working capital adjustment”). To do this, the parties will normally proceed as follows:

As a first step, the buyer and the seller agree on the contractual definition of working capital. There is no generally valid definition for it. During the negotiations, the parties will therefore either adopt commonly used definitions or ones that are especially favourable to their respective position. A basic distinction needs to made between the fundamental components of working capital: 

• Trade Working Capital – which is directly necessary for the day-to-day business activities
• Other Working Capital – other items of current assets that are not included in the trade working capital, nor in the net debt (i.e. the net financing requirement to be deducted when deriving the purchase price using EBIT or EBITDA), which the target company needs to have available at short notice for its business activities.

The basis is the trade working capital, to which the following items are usually attributed (with a positive or negative sign as appropriate), and which can usually be defined without any major issues:

• Inventories
• Accounts receivable
• Accounts payable and advance payments received
• Provisions for outstanding purchase invoices.

Other Working Capital then includes a wide range of items that are only introduced in the calculation on the basis of individual agreement by the parties, such as:

• Operational and restricted cash and cash equivalents
• Outstanding deductible VAT
• Liabilities for taxes, wages and salaries
• Deferred expenses and deferred income
• Provisions for personnel costs, warranties, etc.

Once the parties have agreed on a joint definition of working capital, there then follows in a second step the analysis of working capital, including any adjustments or normalisation. Typically, the last three years prior to the transaction are analysed for this purpose, so that changes in working capital and other trends and internal dependencies can be determined. In addition to a year-on-year analysis of key indicators (cash conversion cycle, days inventory outstanding, etc.), a working capital analysis over the year is absolutely necessary as the only way of uncovering seasonal fluctuations.

Normalisation of working capital serves to adjust historical values for one-off or extraordinary events, e.g.:

• excess inventories due to an exceptional project
• emergency or special cases.

As part of the normalisation, the circumstances that can be expected due to the transaction itself are also modelled:

• renegotiation of payment terms with suppliers and customers
• changes in working capital management
• elimination of intra-group business relationships, etc.

In a third step, there is a choice of application methods. Depending on the selected approach for determining the purchase price, the following options are normally available:

• Target working capital (in closing accounts)
• Cut off at a locked box date.

For example, if the parties agree to a closing account mechanism, initially only a provisional purchase price is agreed in the contract. The closing accounts, prepared after the closing date, form the basis for determining the final purchase price. Based on the closing accounts, the amount of working capital is calculated as at the date of closing. The difference between this working capital and the target working capital is then included in the post-closing purchase price adjustments.

The target working capital can be agreed by the parties as a fixed value in the calculation formula (e.g. the result of an extrapolation of the historical normalised working capital), as an average value, or as a percentage of sales revenues.

If the parties are inclined to agree on a fixed purchase price in the contract, an advance working capital analysis and normalisation should still take place. A comparison is then made to the working capital at the selected reference date. The result can be incorporated into the negotiations that determine the amount of the fixed purchase price.

The inclusion of a mechanism for a working capital adjustment in the purchase price calculation, together with the comprehensive definition and analysis of working capital, has a considerable impact on the purchase price. However, it is not uncommon for its relevance and impact to be underestimated. The buyer needs to be made aware of the risk of purchase price manipulations in the absence of a suitable adjustment mechanism. Illustrations using sample calculations will regularly surprise the parties, and convince them of the need for careful and competent handling of this topic.

Our consulting practice has taught us that designing working capital adjustment clauses is a topic for specialists, due to the complexity and heavy reliance on formulae. The early involvement of experienced experts in the design and negotiation of appropriate purchase price clauses is therefore strongly recommended.