Negotiating working capital adjustments in private M&A transactions


Financier Worldwide Magazine

April 2014 Issue

April 2014 Issue

Most private company acquisition agreements contain working capital adjustment provisions to ensure that the purchased business has an appropriate level of working capital. While working capital adjustments may take many forms, there are certain provisions that must be carefully drafted in order to maximise the efficacy of any such adjustment. The following sets forth a brief description of areas in which buyers and sellers should focus their attention to carefully construct working capital provisions in private acquisition agreements. 

Defining working capital. Perhaps the most fundamental issue in drafting a working capital adjustment provision is defining working capital. While working capital is generally defined as current assets less current liabilities, the determination as to what is considered a current asset and what is considered a current liability is not always so clear. Careful attention should be paid to how the target business has defined current assets and current liabilities in its historical financials. At a minimum, the parties should review whether the target business has included any items as long term assets that are more appropriately characterised as current assets or whether any current liabilities should really be characterised as long term liabilities. In addition, to the extent applicable to the target business, the parties should define working capital with specific reference to how cash, cash equivalents, prepaid expenses, inventory, accrued expenses, trade payables, customer deposits and deferred revenue should be treated. The parties may also wish to include a schedule setting forth an example of how working capital will be calculated on a line item by line item basis for the target business. The benefit of having an example of the calculation is that the example would be reviewed by all parties and agreed to at the time that the acquisition agreement is signed. 

Past practices and accounting standards. It is important to keep in mind that for a comparison of the closing working capital to the target working capital, the two calculations must include the same line items and use the same accounting principles. Adhering to GAAP, IAS or other applicable standards is a good start, but the historical financials of the target business might not have been compliant with the applicable standards, which could create problems when comparing working capital amounts. If the parties specify that the working capital statements shall be based, for example, on ‘GAAP consistently applied’ in the target business’s historical financials, then the requirements under GAAP may conflict with how the target business has historically prepared its financials. Moreover, accounting rules permit different treatment for the same item in some cases (for example, doubtful accounts). The parties should be clear when a variation from the applicable standard is allowed, how items that may be treated differently under the standards will be treated for the purposes of the working capital adjustment and which principles will prevail in the event of a conflict between the standards and the target business’s past practices. 

Moreover, most acquisition agreements will contain a representation that the historical financial statements of the target business have been prepared in compliance with the applicable standards. If the target business’s working capital calculations do not comply, but the buyer’s do, the resulting working capital difference might be considered a breach of the representations regarding the financial statements of the target business, which may result in an indemnification claim and not a working capital adjustment. See OSI Systems, Inc. v. Instrumentarium Corp., 892 A.2d 1086 (2006). In addition, the parties should address any variations in working capital due to non-recurring transactions, seasonality in the business or other factors that may result in a ‘lumpy’ or an atypical amount of working capital during the measurement period. 

Specifically address known matters.Certain assets or liabilities may also be addressed in other provisions of an acquisition agreement and the working capital adjustment provisions should specifically address whether these items are included in the working capital adjustment. For example, in Brim Holding Co., Inc. v. Province Healthcare Co., 2008 Tenn. App. Lexis 325 (Tenn. Ct. App. May 28, 2008), Province agreed to indemnify Brim for any losses arising out of a particular pending lawsuit. After signing, Brim settled the lawsuit and sought indemnification from Province; however, Province refused to indemnify Brim. Province claimed that because there was a reserve on the balance sheet for the potential settlement liability, which effectively reduced the purchase price through the working capital adjustment, if Province were to indemnify Brim, it would result in a ‘double recovery’. However, the court disagreed, stating that the indemnification provision as written in the acquisition agreement obligated Province to pay for any losses from the suit, without reference to the working capital. The court noted that if the parties wanted to account for this potential liability in either the indemnification or working capital provision, but not both, then they should have done so explicitly. Careful attention should be paid to eliminating any possibility for ‘double recovery’ as well as specifically addressing how any issues identified in due diligence will be treated – are they matters that should flow through working capital or should the appropriate remedy be recovery under the indemnification provisions?

Interaction with indemnification. Determining sufficient working capital amounts can be a moot exercise if other provisions of the acquisition agreement conflict with, or also apply to, the working capital adjustment. As noted above, in Brim, the parties arguably double-counted the lawsuit’s potential liability by reflecting the amount in working capital and creating an indemnification obligation for the liability.

More commonly, an acquisition agreement would specifically state in the indemnification provisions that any amounts that were accounted for in the working capital adjustment would not also be available for indemnification. Parties should also pay attention to whether any recovery is subject to any limitations, such as deductibles baskets, and caps, that may apply to indemnification obligations. If the acquisition agreement is not specific, the amount that a party is entitled to recover may vary depending on whether the claim is brought under the working capital adjustment provisions, which typically do not contain limits on recovery, or the indemnification provisions, which typically do contain limits on recovery. The parties should take care to ensure that the working capital adjustment provisions do not overlap, or conflict, with the other provisions in the acquisition agreement.

Dispute resolution. In the event of a dispute, the parties should have confidence that the acquisition agreement adequately addresses the process for resolution of the dispute in a timely and efficient manner. In many cases, the parties will specify that an independent accounting firm will resolve any working capital disputes by using the same accounting principles applied in determining the working capital at the target business. However, the parties should clearly state how a working capital dispute, in all forms, will be handled. For example, in OSI, the dispute ended up being determined by the broader dispute resolution procedure in the acquisition agreement, because the dispute was not viewed as a working capital dispute, but rather an issue as to the interpretation of the acquisition agreement. If the parties’ intention is that a third party accounting firm will resolve every working capital dispute, including differences in accounting principles, then the acquisition agreement should state this explicitly. Finally, to ensure that a working capital adjustment dispute is not appealed, the parties should also provide that the decision of any independent accounting firm is final and binding and may not be appealed. 

Working capital adjustments are an important part of many private acquisition agreements. Drafting an appropriate working capital adjustment involves thinking through several issues. Initially, the parties will need to agree on what constitutes working capital, what accounting principles will help to guide those determinations and what level of working capital is sufficient to fund the continuing operations of the target business. However, because the working capital adjustment does not exist in a vacuum, the parties should take particular care to explicitly state how the working capital adjustment will interact with any issues identified in due diligence and how any adjustment in respect of working capital will be treated in the context of the acquisition agreement’s other provisions, specifically indemnification provisions. Both buyers and sellers should pay careful attention to how the working capital adjustment provisions are drafted in light of the specific due diligence, accounting, financial and other particulars of the target business in order to minimise the risk of a dispute and ensure the parties are getting the benefit of their bargain.


Corby J. Baumann is a partner and Justin D. Tillson is an associate at Thompson Hine LLP. Ms Baumann can be contacted on +1 (212) 908 3933 or by email: Mr Tillson can be contacted on +1 (513) 352 6698 or by email:

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Corby J. Baumann and Justin D. Tillson

Thompson Hine LLP

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