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Merger and acquisition (M&A) lawyers and accountants spend an inordinate amount of time negotiating, interpreting, and sometimes litigating working capital provisions. Is all this fuss really necessary? The answer is that it depends. In order to fully answer this question, it is necessary to first understand how the working capital adjustment provisions typically found in merger and acquisition agreements actually work. It is equally important to look behind the provisions and be clear on what they are intended to achieve. Only then can you get a clear picture as to whether a long, drawn-out negotiation over working capital is worth the effort.
WHY WORKING CAPITAL MATTERS
Most purchase and sale agreements contain one or more post-closing purchase price adjustment provisions, the most common of which is a working capital adjustment. Buyers want to ensure that they buy a business on a basis in which it has sufficient working capital to meet the immediate cash needs of the business, including obligations to employees and trade creditors. Buyers typically base their purchase price for a business on a "going concern" basis and do not want to contribute additional capital immediately after closing. Conversely, sellers want to retain the earnings and profits of the business generated for periods prior to closing.
The understandable desire of buyers and sellers to preserve or protect the value they bargained for is straightforward in concept but unfortunately often results in protracted negotiations and complicated contractual provisions.The problem is that the purchase price is typically based on historical and projected earnings and a normalized balance sheet. Most transactions contemplate a certain amount of time between signing, and closing and financial statements are rarely available for the exact moment when a purchase agreement is signed. Accordingly, the parties need to make certain assumptions on which the purchase price is based. These assumptions become a baseline, and the purchase agreement usually contains a true-up mechanism to ensure that the seller's financial situation at closing has not changed one way or another between signing and closing. In the absence of such a provision, any increase in working capital after a deal is signed would result in a windfall to buyer and any decrease would effectively increase the purchase price.
IT'S ALL IN THE DEFINITIONS
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