PLANNING BEYOND THE SALE OF A BUSINESS: UNDERSTANDING WORKING CAPITAL ADJUSTMENTS

• The most common post-sale dispute involves determining the working capital of the sold business.
• In planning for the sale, the parties should agree on what is a normal working capital amount, as well as the elements of working capital.
• Careful planning in the purchase agreements can greatly diminish a post-sale dispute.

Planning for the sale of a business must extend beyond the close of the actual transaction. Preparations must be made to simplify the resolution of disputes that could arise between buyers and sellers. Litigation in connection with the sale may occur over a variety of reasons, including breaches of the seller’s representations and warranties, or determining post-sale milestones that trigger contingent purchase price payments. The most common post-sale dispute, however, involves determining the working capital of the sold business. The difference between a buyer’s determination of working capital at closing and the amount perceived by a seller is often tens or hundreds of thousands of dollars. The poster child for the importance of this issue is the 2015 dispute between Westinghouse Electric and Chicago Bridge & Iron, where the dollar differential was in excess of $2 billion. Litigation lasted over two years.

To operate a business in its traditional manner, whether the sale of the enterprise is an equity or asset sale, all buyers expect that the business will be left with sufficient working capital to operate on a day-to-day basis. The parties must recognize that a business is not a stagnant creature. Every day, products are shipped, receivables are collected, and invoices are paid. The sale price should not be affected by the happenstance of a day’s collection of receivables or that the closing occurs the day prior to the weekly check run. The absolute value of the business doesn’t change; therefore, neither should the purchase price.

In planning for the sale, the parties should agree on what is a normal working capital amount, as well as the elements of working capital. Working capital generally consists of accounts receivables, inventory, and other current assets less accounts payables, accrued payroll,
customer deposits, and other current liabilities. Cash is generally retained by a seller, even in equity sales. Accordingly, cash is excluded from the working capital calculation.

The parties often average the month’s ending working capital amount over a six- to twelve-month period. The seasonality of a business may necessarily be factored into account. Further, in a fast-growing business, a working capital target based on anticipated growth may be more appropriate than one based on historic performance. This is especially true if the purchase price is primarily based on anticipated future revenues or profits. The parties agree that if the actual working capital is over the predetermined amount, the buyer will pay the difference. However, if the actual working capital is below the target, the purchase price is reduced. Recognizing that working capital will change daily, rather than agreeing on a fixed number, parties may agree on an average range. This eliminates the need for a seller to micro-manage the business in the days preceding the sale. Moreover, it may also negate a seller’s tendency to accelerate the shipment of product to a date before closing and convert inventory into higher-valued receivables. For example, if the range is between $1 million and $1.2 million, then a price adjustment occurs only if the actual number is above or below the range.

In many instances, a buyer in an asset transaction will not want to acquire any liabilities (other than contracted obligations for future performance). In those instances, the working capital adjustment will look only at current assets. In some instances, however, a buyer may assume vacation and sick-day accruals to employees. Otherwise, although the seller may make these payments at closing, when the employee takes the time off, there will be no payments to him or her, potentially creating an employee morale issue.

In setting both the working capital target and the closing date working capital amount, it is critical that the parties utilize the same measurements. Measurements utilized by the seller in its operation of the business are often not used by the buyer in determining the closing date amount. To illustrate, a buyer will insist on utilizing GAAP accounting practices. These rules would impose bad-debt reserves and/or inventory reserves for slow-moving or obsolete items that were not factored in setting the target number. Many private or small businesses do not utilize such reserves. The inclusion of these reserves would then artificially reduce the purchase price amount where there has been no true change in the business. Other adjustments may be proposed by a buyer that depart from the practices used by a seller. On the other side of the equation, if a buyer accepts that there will be no bad-debt reserve, the seller may be asked to guaranty collections. If a receivable isn’t collected within, for example, 90 days from closing, the seller will pay the buyer the receivable amount, and the receivable is transferred back to the seller.

I have found it extremely useful to include as an exhibit to the purchase agreement an example of working capital as of a prior historical date and a statement that the closing date working capital must be determined utilizing the exact same accounting principles as were used in determining the example’s working capital. The example may also show all categories of current assets and current liabilities used in the calculation, even if the dollar amount in a category in the example is zero. By listing all categories, disputes are eliminated as to whether a current asset or liability is to be included.

Once the buyer prepares the closing date working capital statement, the seller generally is given 20 to 30 days to review the statement. If the seller agrees with the conclusions, the closing adjustment amount is paid either by the buyer (if the working capital target is exceeded), or by the seller (if there is a deficiency). If the seller disputes these calculations, the buyer and seller generally are provided a few weeks to see whether they can resolve the dispute themselves. If they can’t, the matter should be referred to a neutral accountant for resolution.

Due to the nature of the conflict, a working capital dispute is best resolved by an accountant rather than by a judge in a lawsuit or by an arbitrator. Restrictions are often placed on the accountant to decide wholly in favor of one side or the other on individual matters and not to try and mediate a compromise. Selection of the accountant should be made before a dispute arises, and the name of the independent accountant should be specified in the purchase agreement. Accountant fees can be either split equally between the parties, or paid by the party who fails to prevail in the dispute resolution.

Finally, sellers must be aware that, similar to a holdback or escrow utilized by buyers to protect themselves against breaches of the representatives and warranties, buyers generally want a short-term holdback or escrow for the working capital adjustments. Buyers generally do not want to chase sellers for monies owed. If there is already an escrow established for the buyer’s benefit for breaches of representations or warranties, then including the working capital holdback should not be an issue. However, if there is no existing escrow, then a short-term holdback is likely more cash efficient.

As noted at the beginning of this article, controversies on working capital adjustments are the most common dispute between buyers and sellers. Careful planning in the purchase agreements can greatly diminish such issues.

Michael Ellis is a corporate and securities attorney with over 40 years’ experience.  He practices in the Cleveland office of Buckingham Doolittle & Burroughs, LLC. His focus includes the area of mergers and acquisition and counseling clients, including start-up and emerging growth companies, in equity, debt, and other capital financings. He also advises shareholders and partners in corporate formations and other governance issues.

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