Working capital affects the final purchase price through correction mechanisms that compensate for deviations from a predetermined reference level. Higher than expected working capital increases the purchase price, while lower levels lead to a discount. These adjustments protect both parties from unexpected fluctuations in working capital needed for day-to-day operations.
What is working capital and why is it crucial in acquisitions?
Working capital consists of current assets minus current liabilities and represents the capital a company needs for day-to-day operations. It includes inventories, accounts receivable and cash and cash equivalents, less accounts payable and other current liabilities.
At M&A-transactions, working capital is a critical factor because it determines operational continuity. Buyers want certainty that the company will have sufficient funds to operate normally after acquisition. Sellers, on the other hand, want to avoid leaving more working capital than necessary for operations.
The crucial role of working capital lies in the timing of cash flows. Inventories must be financed before they are sold, debtors represent outstanding payments, and creditors provide temporary financing. This cycle requires a careful balance sheet that directly affects enterprise value.
How exactly is working capital calculated in an acquisition?
Working capital calculation in acquisitions follows a standardised methodology in which specific balance sheet items are identified and valued. The calculation starts by determining operating working capital, which is limited to items directly related to operations.
Operating working capital includes trade receivables, inventories and accruals, less trade payables and accruals. Cash and cash equivalents, short-term loans and tax liabilities are generally left out of the calculation as they are treated separately in the transaction structure.
The difference between operational and total working capital lies in the scope. Total working capital includes all short-term items, while operational working capital focuses on trade-related components. This focus avoids discussions on financing decisions that are not part of normal operations.
The exact definition will be set out in the Letter of Intent and later detailed in the purchase agreement. Both parties must agree on which items will be included and how they will be valued on the closing date.
What happens if working capital is higher or lower than expected?
Working capital adjustments compensate for deviations between actual working capital at closing date and the pre-agreed reference level. This correction mechanisms Ensure fair distribution of working capital fluctuations between buyer and seller.
If the working capital is higher than the reference level, the seller receives a plus adjustment on the purchase price. This offsets the extra capital invested in the business. Conversely, lower working capital results in a minus correction, where the purchase price is reduced because the buyer receives less operating capital.
A practical example: if the reference working capital is €2 million and the actual working capital at closing date is €2.3 million, the seller receives €300,000 extra purchase price. With an actual working capital of €1.8 million, the purchase price is reduced by €200,000.
Corrections can be limited by minimum and maximum thresholds (collars and caps). These mechanisms prevent small fluctuations from leading to adjustments and protect both parties from extreme outliers that are not part of normal business variation.
When is working capital determined during a merger or acquisition?
Working capital determination takes place on the closing date, the time at which ownership formally passes. This timing differs from the reference date, which serves as a benchmark for the reference working capital and is usually a historical balance sheet.
The reference date is often chosen based on a normalised period representative of normal operations. This may be the end of the last financial year or an average of several periods to smooth out seasonal effects.
Seasonal fluctuations require special attention in timing. Companies with strong seasonal patterns can show significant working capital variations. For example, a toy manufacturer has high inventories for the Christmas period, while an ice cream producer peaks in the summer.
The business cycle also influences the timing of working capital determination. Companies with long production cycles or extended payment periods show different working capital patterns than those with quick turnarounds. These factors are taken into account when determining reference levels and adjustment mechanisms.
What pitfalls should you avoid in working capital negotiations?
Unclear definitions are the biggest pitfall in working capital negotiations. Parties need to specify exactly which balance sheet items are included and how they are valued. Vague descriptions lead to disputes during closing and may delay or cause transactions to fail.
Wrong reference periods can distort working capital levels. A reference period during an exceptional period gives an unrealistic picture of normal working capital. Due diligence should analyse historical patterns to establish representative reference levels.
Insufficient attention to accounting differences creates risks. Different valuation methods for inventories or debtors can affect working capital. Harmonisation of accounting principles prevents unexpected corrections.
Due diligence plays a crucial role in identifying working capital risks. Analysis of historical trends, seasonal patterns and business cycle helps establish realistic reference levels. Professional guidance from experienced advisers prevents costly mistakes and ensures balanced working capital arrangements.
Working capital negotiations require in-depth knowledge of both financial structures and transaction dynamics. We guide parties in structuring working capital arrangements that protect both parties and make transactions run smoothly. For professional support on working capital issues in your transaction, contact contact with us.
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