In negotiating the sale of a business, a buyer and seller will often agree to adjust the purchase price based on the amount of the business’ working capital on hand at the time of the closing. Often, the parties underappreciate the importance of this adjustment until after the closing when disputes arise. Depending on the mechanism that the parties specify in their purchase agreement and the conditions of the business at closing, the adjustment may significantly alter the final price the buyer ultimately pays the seller for the business.
In our December 2014 edition of Raising the Bar, Navigating Post-Closing Purchase Price Disputes, we describe this dispute resolution process and the steps a party can take to protect its interests once a dispute arises. In this issue, we provide information to help identify and mitigate some of the most critical underlying working capital issues before a dispute arises.
Working Capital Adjustments Background
Although parties may define working capital in numerous ways, a general accounting definition of working capital defines the term as current assets minus current liabilities. Frequently, the buyer and seller may specifically agree to include or exclude certain line items in calculating working capital. The parties’ purchase agreement should specify the relevant accounting principles and methodologies to calculate working capital (e.g., GAAP, IFRS, historical practices, or other agreed upon methodologies).
The buyer and seller will typically state a financial target (often referred to as a “peg”) for the total amount of working capital at closing. To the extent that the company’s working capital at closing is greater than the peg, the buyer is required to pay a higher purchase price to the seller and vice versa.
Typically, there is an initial estimate (made prior to the closing date) of the working capital amount, which the parties use to calculate the payments to be made on the closing date. After the closing date, the parties adjust the estimate to reflect actual balances. If the parties are not able to agree upon this calculation, they frequently engage an accounting arbitrator to resolve the dispute.
Common Causes of Working Capital Disputes
GAAP vs. Consistency
Within the purchase/sale agreement, parties may view the purpose of the working capital calculation in two different manners. First, some consider the purchase price adjustment as a mechanism solely to account for changes in the company’s financial condition occurring between the execution of the purchase agreement and the closing date. These parties believe the closing balances should be calculated in a manner consistent with the company’s historical methodologies. By maintaining consistency with those accounting methodologies, the purchase price adjustment will only result in a payment for economic changes – not for any changes in accounting practices.
Conversely, other parties view the working capital calculation as a way to guarantee that the buyer receives a business with a specified amount of working capital at closing (i.e., the peg amount). Those parties believe the working capital should be measured in accordance with generally accepted accounting principles (GAAP), or other accounting principles mutually agreed to by the parties. By strictly adhering to GAAP in the calculation, the buyer and seller will be assured that the purchase price is adjusted for the absolute difference between the company’s actual working capital at closing and the stated peg amount.
Therefore, if historical accounting methodologies are not in accordance with GAAP, an obvious conflict arises: should the company’s working capital at closing be measured consistently with its historical methodologies or should it be re-measured using GAAP? Further, what methodology should be used if multiple methodologies each conform to GAAP? These questions frequently lead to disputes, because purchase agreements often fail to address any potential conflict. For example, common language in purchase agreements states that the financial condition (e.g., working capital) shall be calculated “in accordance with GAAP, applied in a manner consistent with the company’s historical financial statements.” When drafting purchase agreements, buyers and sellers should determine the rationale for the working capital adjustment that they are utilizing and explicitly state whether GAAP or historical practices shall prevail in the event they conflict.
Consideration of Subsequent Events
Calculating the working capital as of the closing may include an evaluation of events after closing that provides information on the company’s condition as of closing. Parties in a dispute frequently argue that such an evaluation is in accordance with GAAP. Subsequent events sometimes give specific, credible information regarding closing date accounting measurements. For example, subsequent collections from customers may provide information on the collectability of receivables as of the closing and the appropriate balance for net accounts receivable.
However, the adjustment process creates at least two questions that may result in additional disputes regarding subsequent events:
- How long after closing should subsequent events be considered?
- Do the subsequent events provide information regarding circumstances that existed as of the closing, or do they represent changes in economic circumstances occurring after the closing?
With respect to the first question, it is impractical to consider subsequent events indefinitely. Further, such a process might unfairly favor the buyer, which typically has more access and information regarding events affecting the company after closing than the seller. GAAP requires that subsequent events be reviewed until financial statements are issued or available to be issued – but the application of this requirement may be unclear with respect to post-closing purchase price disputes. Some parties believe financial statements are “issued” when a party (usually the buyer) delivers the original closing statement, while others believe the statements are not “issued” until all disputes are resolved (either by mutual agreement by both parties or through arbitration or litigation). The former alternative requires a cut-off date on or before the due date of the first party’s submission of its calculation to the other party. The latter alternative may extend years after the closing date. Either way, both alternatives may lead to vastly different balances for various assets and liabilities, particularly those requiring a judgment in calculation.
Regardless of the date through which subsequent events are considered, the parties may disagree as to whether the subsequent events provide evidence regarding economic circumstances that existed as of the closing. For example, if a business has a potential legal liability as of the closing and reaches a settlement on the obligation after the closing date, the buyer may argue that settlement provides evidence of the actual value of the contingent liability at closing. However, the seller will often argue that it would not have permitted the company to reach such a settlement agreement and that the settlement agreement represents a post-closing action taken by the buyer that is irrelevant to closing balances.
When drafting purchase agreements, buyers and sellers may benefit from specifying (i) the date through which the parties shall evaluate subsequent events and (ii) what types of subsequent events (if any) should be considered (or expressly excluded) when calculating working capital. Both parties should also consider to what extent subsequent events were considered in preparing the company’s historical financial statements or in creating peg amounts, as well as the impact that reviewing subsequent events may have on the duration of working capital disputes.
Items Included in Working Capital
The purchase agreement should specify what is to be included in the measurement of the company’s working capital. For example, the parties should define the current assets and current liabilities that are to be included in the calculation. However, these definitions can frequently cause disagreements. In the instance of a working capital dispute, which typically includes only current (i.e., short-term) assets and liabilities, the parties may differ on the classification of certain accounts or amounts as current or noncurrent (i.e., long-term). A party may argue that an item historically accounted for by the company as current is actually noncurrent and, therefore, must be excluded from the calculation of closing working capital. Such an argument may have a basis in GAAP, but runs contrary to the principle of consistency.
When drafting purchase agreements, the parties should consider including a schedule that explicitly identifies the accounts to be included in the measurement of the company’s financial condition. The agreement language should be written to convey the intent of the parties and to prevent future attempts by either party to modify the accounts to be included in the purchase price adjustment calculation. Notwithstanding the foregoing, buyers must be cautious in drafting such language and schedules, because the language may unintentionally exclude liabilities that the buyer is unaware of prior to closing. If such conditions exist, the buyer may be unable to subtract the value of the previously unknown liabilities when calculating the financial condition of the business at closing for the purchase price adjustment.
Buyers and sellers should work together with their legal and accounting advisers when drafting purchase agreements to mitigate the risk of such disputes. Although disagreements frequently occur, a limited number of attorneys and accountants actually specialize in these matters. Buyers and sellers routinely engage accounting experts in purchase price adjustment matters; however, such experts are often retained only after a post-closing dispute arises. Retaining an expert prior to executing a purchase agreement may prove to be valuable in mitigating risks inherent in ambiguous or unfavorable purchase agreement language. This enables the expert to add value throughout the complete adjustment process life cycle including drafting purchase agreement language; preparing closing date calculations; negotiating differences; selecting an arbitrator; and participating in arbitration or litigation.
 As of the date of this article, guidance for subsequent events is contained in Accounting Standards Codification Topic 855.