M&A Vocabulary – Understanding Experts: “Working Capital Adjustment”

In a classic business acquisition, the target company is viewed as a system designed to generate profits. A key prerequisite for this system to function is the availability of operating capital. Operating capital (“Working Capital”) is – in simplified terms – the assets (inventories, receivables, etc.) tied up in the operating cycle.

For a business acquisition, it is assumed that at any given time, under the prevailing circumstances, there is a natural or characteristic level of working capital for the target company that is exactly sufficient for ongoing operations. The purchase price is determined on the premise that the target company is equipped with the necessary – but not excessive – working capital. However, if the actual amount of working capital present at a specific date deviates upward or downward from this necessary or sufficient level, this should be ensured through the establishment of an adjustment mechanism in the Purchase Price Calculation (so-called “Working Capital Adjustment”). To this end, the parties typically proceed as follows:

In the first step, the buyer and seller agree on the contractual definition of working capital. There is no universally applicable definition. During negotiations, the parties therefore start from commonly used definitions or definitions that are particularly favorable to their respective positions.

When it comes to the fundamental components of working capital, a distinction must be made between:

• Trade Working Capital – current assets directly required for day-to-day operations
• Other Working Capital – other current asset items not included in Trade Working Capital or Net Debt (i.e., the net financial debt regularly deducted in the purchase price derivation via EBIT or EBITDA) that must be available to the target company in the short term for its operations

The basis is Trade Working Capital, which typically includes the following items (each with a positive or negative sign) and can usually be delineated without major problems:

• Inventories
• Trade receivables
• Trade payables and advance payments received
• Provisions for outstanding incoming invoices

Other Working Capital includes a broad range of items that are only included in the calculation based on individual agreement between the parties, such as:

• Operationally necessary and committed liquid funds
• Input tax claims
• Liabilities from taxes, wages and salaries
• Prepaid expenses and deferred income
• Provisions for personnel costs, warranties, etc.

Once the parties have agreed on a common definition of working capital, the second step involves an analysis of working capital, including adjustments or normalization. Typically, the last three years prior to the transaction are analyzed to determine the development of working capital as well as further trends and internal relationships. In addition to a year-to-year analysis of key metrics (Cash Conversion Cycle, Days Inventory Outstanding, etc.), an intra-year working capital analysis is essential, as this is the only way to identify seasonal fluctuations.

The normalization of working capital serves to adjust historical values for one-time or extraordinary events, e.g.:

• Excessive inventory levels related to an extraordinary project
• Emergency or special cases

During normalization, circumstances expected as a result of the transaction are also modeled:

• Renegotiation of payment terms with suppliers and customers
• Changes in working capital management
• Elimination of intra-group business relationships, etc.

In the third step, the application methodology must be selected. Depending on the chosen method of purchase price determination, the following options are typically available:

• Target Working Capital (closing accounts)
• Reference to Locked Box date

If the parties agree, for example, on a closing accounts mechanism, only a preliminary purchase price is initially agreed in the contract. The basis for determining the final purchase price is the closing accounts, which are prepared after closing. Based on the closing accounts, among other things, the amount of working capital on the closing date is calculated. The deviation of working capital compared to the target working capital is included in the post-closing purchase price adjustment as of the closing date.

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

If the parties are inclined to agree on a fixed purchase price in the contract, a working capital analysis and normalization should also take place in advance. The comparison is then made with the working capital at the chosen reference date. The result can be incorporated into negotiations regarding the determination or amount of the fixed purchase price.

The inclusion of a working capital adjustment mechanism in the Purchase Price Calculation, together with a comprehensive definition and analysis of working capital, has a significant impact on the purchase price. However, the relevance and implications are often underestimated. The risk of purchase price manipulation in the absence of an appropriate adjustment mechanism must also be highlighted to a buyer. Illustrative sample calculations regularly surprise the parties and demonstrate the necessity of careful and competent handling of this issue.

Advisory practice has shown that the design of working capital adjustment clauses is a topic for specialists due to its complexity and inherent formula-heavy nature. Early involvement of experienced experts in the design and negotiation of corresponding purchase price clauses is therefore strongly recommended.

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