Navigating Net Working Capital Adjustments in M&A Deals
In any mergers and acquisitions (M&A) transaction, the net working capital (NWC) adjustment is often one of the most intensely negotiated points. If not properly managed early on prior to closing, we see many disagreements on NWC in post-closing adjustment processes. The NWC adjustment mechanism ensures that the target company delivers an appropriate level of working capital at closing—neither excessively depleting its resources nor accumulating undue surplus—thereby maintaining the business's operational integrity. Determining the target level of working capital and addressing potential post-closing disputes requires a strategic and transparent approach.
Why Net Working Capital Adjustments Matter
Net working capital represents the difference between a company's current assets (e.g., accounts receivable, inventory) and current liabilities (e.g., accounts payable). For buyers, the NWC adjustment protects against scenarios where the seller might overly reduce working capital to maximize short-term cash flow prior to closing, leaving the business undercapitalized. For sellers, it ensures that they are fairly compensated without overfunding the company's ongoing operations.
The adjustment process typically involves establishing a target working capital figure based on historical performance or projected needs. This figure serves as the baseline for determining whether the company’s actual working capital at closing results in a payment adjustment—either from the seller to the buyer or vice versa.
Minimizing Disagreements on Working Capital Adjustments
Define Working Capital Components Clearly: A frequent source of contention arises from ambiguities around which accounts are included in the NWC calculation. Parties should agree early on whether specific items, such as cash or deferred revenue, are part of the calculation.
Use Historical Benchmarks: To set a fair target, examine historical working capital trends over a representative period. Avoid cherry-picking periods that could bias the target figure in favor of one party.
Conduct Pre-Closing Reviews: Thorough due diligence and reconciliation of financials before closing can identify discrepancies and avoid surprises during post-closing calculations.
Implement a Clear Dispute Resolution Mechanism: Include a process in the purchase agreement for addressing disagreements, such as involving a neutral third-party accountant or arbitrator to review the calculations.
5. Gather the Right Team: Working capital adjustments are complex, and having the right accounting team on board to help you through it is crucial. Make sure you have an accounting team with audit capabilities involved in your deal early on.
Conclusion
By addressing the net working capital adjustment proactively and comprehensively, buyers and sellers can avoid costly disputes and ensure a smoother transaction.
If you have any further questions about this post, please contact Julia D. Dennis at jdennis@shuffieldlowman.com or another member of the ShuffieldLowman M&A team.