Be prepared for net working capital disputes
February 2019 | SPOTLIGHT | MERGERS & ACQUISITIONS
Financier Worldwide Magazine
February 2019 Issue
Net working capital (NWC) is a common measurement of a company’s ability to meet its short-term obligations with its current assets. In its basic and most common form, NWC is the excess of current assets over current liabilities as presented on a company’s balance sheet. Many acquisitions are valued based on a ‘cash-free/debt-free’ basis, which means the seller retains the cash and interest bearing debt. In this context, NWC excludes cash and debt.
Most business purchases are valued based on enterprise value which is usually derived from the business’ cash flow. Although NWC is not an element of enterprise value, buyers commonly expect the current assets and current liabilities being transferred upon a purchase to be as close as possible to those required to produce the cash flow on which the valuation is based. Buyers are seeking a level of NWC that is needed to maintain ongoing business operations without an infusion of additional cash. This ‘normal level’ of NWC is more of an art than a science and is carefully assessed by both buyers and sellers. By its nature, NWC regularly increases and decreases based on operations. It is this change in NWC that is critical to cash flow and ultimately impacts a company’s purchase price.
This is why most sellers and buyers will agree to a purchase price adjustment based on the ‘true-up’ of NWC. As a result, a company’s NWC and related components are carefully scrutinised during the period of due diligence. The buyer frequently identifies and challenges certain unusual or disputable elements of NWC, which results in an adjusted NWC. It is not uncommon to have discussions and negotiations on the quality of the proposed adjusted NWC components, with both parties ultimately agreeing to a target NWC to be used in the ‘true-up’.
Determining the quality of the elements of NWC requires the exercise of good judgment and careful due diligence. This includes an assessment of the trends of the business, both current and future, and a validation of the more significant elements of NWC. Some areas of NWC to be carefully considered, are outlined below.
Accounts receivable. Receivables should include only those accounts which are expected to be collected in the normal business cycle. Balances which have extended terms, that are overdue or disputed are typically reserved or excluded from the NWC calculation. Balances from related parties and employees are also typically excluded.
Inventory. Buyers must carefully assess the quality of inventory. Old or obsolete inventory should be reserved or excluded from NWC. In addition, the buyer needs to assess the adequacy of the quantities of inventory and determine the appropriate levels based on post-transaction operations of the business. Insufficient levels will require the buyer to contribute additional capital.
Accruals. Accruals are often based on estimates and judgment. Buyers should carefully scrutinise all significant reserves and accruals which are based on the seller’s judgment. This includes assessing the basis and agreements supporting all significant liabilities and commitments, for example employee wages and bonuses, warranties, litigation and settlements, and rebates, among others.
Timing. Most companies execute a comprehensive financial closing at year-end. In doing so, final estimates, adjustments and ‘true-ups’ are addressed. During the year, the closing process is often less formal and less precise. Unfortunately, most acquisitions are not coordinated with the seller’s year-end. When evaluating the quality of NWC, it is important to ensure that all significant year-end adjustments are addressed during the due diligence period and ultimately are incorporated into the target NWC.
Financial reporting standards. NWC is typically based on the presumption that it was calculated based on financial statements that were prepared in accordance with certain financial reporting standards, such as Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). The NWC of companies that deviate from these reporting standards must be carefully assessed and the parties should agree on the manner in which deviations should be handled.
Upon completing due diligence, the buyer and seller usually negotiate the final adjusted NWC target. The buyer and seller anticipate this balance at closing. A deviation from the NWC target results in a purchase price adjustment, which can often result in purchase price adjustment disputes.
A common driver of purchase price adjustment disputes often centres on the differing views of the buyer and seller regarding the purpose of the post closing NWC adjustment. Buyers often view the purchase price adjustment process as an opportunity to ensure that the actual NWC, as of closing, complies with the financial reporting standard required by the terms of the M&A agreement, such as GAAP, IFRS or the company’s past practice. Sellers, on the other hand, often believe that the purpose of the purchase price adjustment is to measure the change in NWC due solely to the operation of the business between the signing of the agreement and the closing of the transaction. The balance sheet items that are commonly in dispute in determining NWC as of the closing date are often the same items that were reviewed during due diligence. Once one understands the common causes of such disputed items, the buyer and seller can include language in the M&A agreement that can help to minimise such disputes.
Accounts receivable. Financial reporting standards require companies to estimate the amount of accounts receivable that may be uncollectable in the future and reduce the accounts receivable balance by that amount. This is often called an allowance for doubtful accounts or bad debt reserve. Because no one can be certain exactly how much of the accounts receivable will not be collected, an accounting estimate is required to record such an amount. Financial reporting standards do not provide a set formula or specific methodology to calculate this allowance for doubtful accounts. As a result, disputes often arise because different managements, the buyers and the sellers, can have different views on how to estimate that amount. One solution would be to include language in the sale agreement that provides a formula to calculate the allowance for doubtful accounts, thereby eliminating the subjective nature of the calculation when NWC is determined as of the closing.
Accruals. During due diligence, buyers should carefully scrutinise significant accruals. One accrual or liability that is often overlooked when the buyer and seller are negotiating target NWC is the accrual for vacation payable and this often causes a purchase price adjustment dispute. This liability is often forgotten when a company has a ‘use it or lose it’ vacation policy, because at the end of the year a company with such a policy does not have a liability for future vacation payable and as such does not reflect a liability on its balance sheet. However, if the closing of the transaction takes place within an interim period and the company has a ‘use it or lose it’ vacation policy, GAAP would require an accrual for vacation that employees have earned and will be taking during the balance of the year. Buyers will often include such a liability in determining closing NWC because it is required by GAAP, but sellers will dispute such vacation accrual because it was not considered when the target NWC was determined. Purchase price adjustment disputes related to vacation accruals can be minimised if the M&A agreement clarifies how vacation payable should be handled when calculating closing NWC.
Timing. While it is important that all significant year-end adjustments are incorporated into the target NWC, it is also imperative that the M&A agreement clearly identifies how year-end adjustments should be handled when calculating closing NWC in order to minimise the chance for purchase price adjustment disputes. In many companies, more rigour goes into the preparation of year-end financial statements than interim financial statements. Purchase price adjustment disputes occur when a business is sold at an interim period and the buyer prepares the closing NWC as if the closing date was a year-end. The seller often disagrees and argues that in determining closing NWC when the business is sold at an interim period the buyer must follow the seller’s past practices, which do not include the application of year-end accounting procedures. Simply adding a sentence to the M&A agreement clarifying whether or not the closing NWC should be calculated applying the company’s year-end accounting procedures could help to minimise such disputes.
Financial reporting standards. M&A agreements typically include language specifying which financial reporting standard is to be applied in calculating closing NWC. An example is that “the closing NWC shall be calculated in accordance with GAAP consistent with the company’s past practices, policies and procedures”. Disputes arise when the buyer identifies the treatment of an accounting item that it claims was not calculated in accordance with GAAP and changes the accounting in determining closing NWC so that it complies with GAAP. The seller will typically argue that the accounting treatment applied is consistent with the company’s past practices, policies and procedures and therefore the buyer has no right to make a change. Such disputes can be minimised if the M&A agreement specifies whether the accounting standard should be applied, or whether past practice should prevail, if there is a difference.
Due diligence procedures will often scrutinise balance sheet items in order to determine an appropriate level of NWC for a company, which will result in the buyer and seller agreeing on an amount of target NWC. An important element of that process is to insure that the language in the M&A agreement describing how to calculate closing NWC addresses many of the items that are commonly disputed. This should minimise purchase price adjustment disputes and allow the buyer and seller to move forward.
Jeffrey M. Katz and Kevin J. Kaden are partners at BDO USA, LLP. Mr Katz can be contacted on +1 (212) 885 8302 or by email: email@example.com. Mr Kaden can be contacted on +1 (212) 885 7280 or by email: firstname.lastname@example.org.
© Financier Worldwide
Jeffrey M. Katz and Kevin J. Kaden
BDO USA, LLP