Decoding "Net Working Capital" Adjustments in M&A Transactions to Avoid Disputes

The Mintz M&A team recently met with Floyd Advisory regarding working capital disputes.  Floyd penned a great article about arbitrating disputes.  

As a veteran M&A lawyer, the discussion prompted me to consider some best practices for Net Working Capital drafting to avoid disputes.  

I am sharing three of my best practices to avoid getting tied up in expensive post-closing disputes.  

1.  Accurately Define "Net Working Capital" and the Target 

Parties should define "net working capital" (NWC) and targets carefully and consistent with the sellers' financials and the deal structure. 

The standard definition of net working capital (current assets minus current liabilities) is often not appropriate for the working capital definition in an M&A agreement.   

Think of it this way:  NWC is an asset acquired by buyer, so it is important to define what the buyer is buying.  

Typically, the buyer is acquiring only the NWC items that are critical to run the business going forward, such as accounts receivable, inventory and prepaid expenses.  Similarly, there may be certain items of accrued expenses or accounts payable that are not operational and would be excluded from the definition of NWC.  

Similarly, the parties will want to carefully consider how to calculate a fair and appropriate NWC target.   We often see the target calculated using a historical average of say 12 months to average out fluctuations.  We also recommend that parties consider factors like seasonality, industry norms, inventory fluctuations and future working capital needs of a growing business in deciding on the NWC target.  

2.  Reduce Ambiguity in Calculating the Numbers. 

The current assets and current liabilities in the seller's books and records may not accurately reflect the economic impact on the seller.  

The typical accounting standard in deals is GAAP consistently applied.  This can be ambiguous.  Many private company sellers have unaudited financials that may or may not be prepared consistent with GAAP.  

Further, as Floyd Advisory points out, there is a difference between GAAP principals, policies adopted by sellers and the seller's actual underlying practices.  

If the parties are not careful with the purchase agreement language, sellers and buyers may come to different conclusions regarding important items like doubtful accounts and aged accounts receivable.  

The parties should create "balance sheet rules" to make sure the economic impact of the seller's financials are accurately reflected. 

The balance sheet rules should be created by financial professionals from the buyer and seller familiar with the sellers' numbers working together and then documented in the purchase agreement.  

In creating "balance sheet rules", we encourage clients to consider: 

- The seller's policies and practices - keeping in mind that what the seller does and says may be different.   

- Locking down approach and calculations with detailed exhibits and examples in the purchase agreement.  For example, the A/R reserve will include no general reserves and write offs must meet specific criteria.

3. Consider Expedited Dispute Resolution Processes

A post-closing dispute over the "net working capital" is never pleasant.  The closing rush has long since subsided and the buyer is likely busy with integration.   

Yet, we see a lot of post-closing NWC disputes.  According to SRS Acquiom, more than 25% of post-closing disputes involve the NWC provision.

In drafting, we suggest to clients mechanisms to limit potential adjustment amounts.  These can include:

- Materiality thresholds below which an adjustment is not made.  

- Arbitration rules such a "baseball-style arbitration" that discourage parties from taking aggressive positions or using arbitration to reach a split-the-baby conclusion.   

- Advising sellers to compile all relevant supporting documentation for its Net Working Capital calculations prior to closing to reduce post-closing access issues.

After a dispute arises, we advise clients on techniques to reduce friction in the dispute.  These can include:

- Careful selection of the arbitrator based on whether the issue is related to GAAP versus contract interpretation.  

- Agreeing to specific arbitration rules to limit the use of discovery and expert witnesses.  

- Weighing the costs and benefits of a formal disputes over NWC.  In particular, buyers may want to consider the distraction from integration or the effect of the dispute on a key stakeholder of seller that is employed by buyer.