Working Capital Purchase Price Adjustment Clause
(Short Form)

Summary

This short form working capital purchase price adjustment clause provides for a one-step adjustment of the purchase price based on deviation from an estimated working capital amount. This clause contains practical guidance and drafting notes. Click here to see recent examples of purchase price adjustment provisions, earn-outs, and escrows in publicly filed transaction agreement in Market Standards—M&A, the Practical Guidance database of publicly filed M&A deals that enables users to search, compare, and analyze transactions using 150+ M&A deal points to filter search results. You can customize any search to your needs by adding filters or modifying the search criteria. A working capital purchase price adjustment is used to ensure that the acquired business has sufficient cash post-closing to allow the buyer to continue operating the business in the ordinary course without the need to invest any amount in excess of the agreed-upon purchase price—which may result in the buyer overpaying for the business. A working capital purchase price adjustment clause also can be used to protect the seller if the working capital increases between the time of determining the initial valuation and the closing date, which would effectively result in the buyer getting a windfall. This type of purchase price adjustment can be especially important in the context of an auction or during a time when there is significant competition for acquisition transactions. Under these circumstances a buyer will have limited or no opportunity to perform diligence on the target business prior to determining a purchase price to be included in a bid, letter of intent, or term sheet, or the buyer will otherwise have an incentive to select a purchase price that is high enough to top its competition. In this environment, a buyer can provide for a working capital purchase price adjustment to protect against issues that may arise during the diligence process and after its bid or offer to purchase the business at a set purchase price has been accepted by the seller. Mechanics of a Working Capital Purchase Price Adjustment A working capital purchase price adjustment is typically structured by the parties agreeing to a definitive working capital peg or working capital target amount at the time the acquisition agreement is signed. The working capital peg is customarily based on the historical operation of the acquired business as reflected in its recent balance sheet. Following the closing of the acquisition, the defined peg or target amount is measured against the estimated working capital amount set forth on a balance sheet of the target company prepared as of the closing date. If the working capital amount set forth on the closing balance sheet is less than the estimated working capital amount, the seller will pay to the buyer the amount of the deficiency; if the working capital amount on the balance sheet is greater than the estimated working capital amount, then the buyer will pay to the seller the amount of such excess. In some transactions, the working capital amount is estimated shortly before the closing date, the purchase price paid at closing is adjusted in accordance with such estimate, and then a final calculation is made post-closing which is then trued up in accordance with procedures set forth in the acquisition agreement. For this type of adjustment see Working Capital Purchase Price Adjustment Clause (Long Form). Drafting a Working Capital Purchase Price Adjustment Provision The basic elements in a working capital purchase price adjustment provision include: (1) how the working capital and its components are to be calculated, (2) the accounting principles to be used in the connection with the adjustment, (3) the interaction of the working capital adjustment provision with other sections of the acquisition agreement, and (4) how any disputes relating to the working capital adjustment will be resolved. Calculation of Working Capital At its most basic, "working capital" is determined by subtracting current liabilities from current assets. Current liabilities are liabilities due within one year and include items such as accounts payable, accrued liabilities or "reserves," and short-term debt. Current assets are assets that become cash within one year and include cash, cash equivalents, accounts receivable, inventories, and prepaid expenses. The parties will typically negotiate which items are taken into account in the calculations of current assets and current liabilities based on the terms of the acquisition. For instance, if cash is being retained by a seller, then it will be excluded from current assets. With respect to prepaid expenses, the current asset calculation will commonly include only those expenses which the buyer will benefit from going forward. In an asset purchase transaction, current liabilities will exclude liabilities that the buyer is not assuming, such as accrued employment obligations or accruals or reserves for litigation. Acquired businesses that have significant cyclical changes to working capital, such as retail businesses, may need special provisions to take into account the proposed timing of the closing, which may unfairly benefit the buyer or seller. Therefore, there is no one-size-fits-all model for calculating working capital, and the manner in which current assets and current liabilities are defined, and how working capital is ultimately determined, must be adapted to the specific target business and the specific terms of the acquisition. Accounting Principles and Methodologies It is critical that the parties agree to the accounting principles and methodologies to be used in the preparation of any financials relating to the working capital adjustment and that such principles and methods are used consistently in the determination of the working capital peg and the estimated and final working capital amounts. A buyer and seller cannot simply default to language stating that a balance sheet and any purchase price adjustment must be calculated in accordance with "generally accepted accounting principles" (GAAP), since GAAP may recognize variations for determining the same balance sheet item. In addition, a seller may seek that the application of GAAP to the adjustment will be done in a manner that is "consistently applied" with the acquired business's past practices, methodologies, assumptions, classifications, and procedures. To address these issues and as a method of minimizing future disputes, it is commonplace for a working capital adjustment provision to refer to an exhibit or schedule setting out the particular financial line items that will be used in calculating the working capital, the accounting principles, policies, and assumptions to be applied along with one or more sample calculations. Relationship with Other Provisions The manner in which the purchase price adjustment and indemnification provisions in an acquisition agreement work together should be examined to ensure that one party cannot obtain recovery under both provisions of the agreement. Moreover, indemnification obligations are often subject to negotiated limits, such as deductibles, thresholds, and caps, which are not usually found in purchase price adjustment provisions. Therefore, if a party has an alternate or additional mechanism through a purchase price adjustment clause for obtaining recovery upon the occurrence of a certain event, the parties' carefully negotiated constraints on indemnifiable liabilities can be rendered meaningless. In addition to the indemnification provision, the parties should pay attention to covenants relating to the operation of the target business in the period between signing and closing. Certain interim operating covenants, such as those involving sales of assets and capital expenditures, must be thoughtfully drafted to safeguard against a seller manipulating one or more components of working capital to produce a seller-favorable price adjustment. Disputes A purchase price adjustment provision often is subject to a different dispute resolution mechanism than that which governs much, if not all, of the remainder of an acquisition agreement. The majority of adjustment provisions contemplate using a third-party expert, such as an accountant, to solve disputes relating to particular aspects of the purchase price adjustment between the parties. For a purchase price adjustment provision with a more fulsome dispute resolution mechanism, see Working Capital Purchase Price Adjustment Clause (Long Form). For further discussion of purchase price adjustments, see Purchase Price Adjustment Provisions in M&A Transaction Documents. To explore market trends and view representative transaction agreements of publicly filed transactions, see Market Trends 2023: Purchase Price Adjustments and Market Trends 2023: Earn-Outs in Public-Private Deals. Click here to see recent examples of purchase price adjustment provisions, earn-outs, and escrows in publicly filed transaction agreement in Market Standards—M&A, the Practical Guidance database of publicly filed M&A deals that enables users to search, compare, and analyze transactions using 150+ M&A deal points to filter search results. You can customize any search to your needs by adding filters or modifying the search criteria. For a comprehensive list of and links to resources in the Corporate and M&A practice area, see Asset Acquisition Resource Kit, Stock Acquisition Resource Kit, M&A Provisions Resource Kit, Private Merger Transaction Resource Kit, and Public Merger Transaction Resource Kit.