In business transactions, particularly asset purchase agreements (APAs) and stock purchase agreements (SPAs), “working capital” is a key financial concept that can directly affect the purchase price and the condition of the business at closing. In most deals, working capital is defined as the difference between current assets and current liabilities, calculated in accordance with Generally Accepted Accounting Principles (GAAP) or another agreed-upon accounting framework.
Working Capital Adjustments in M&A Transactions
APAs and SPAs commonly include working capital adjustment provisions to account for changes in the target company’s financial position between signing and closing. These provisions are intended to ensure that the buyer receives a business with a level of working capital consistent with what was negotiated.
To accomplish this, the parties often agree on a “target working capital” amount, sometimes referred to as a “peg,” which is typically based on the company’s historical financial statements. At closing, the company’s actual working capital is calculated and compared to the target. If actual working capital exceeds the target, the purchase price is generally increased. If it is below the target, the purchase price is reduced.
The Importance of Consistent Accounting Methodologies
The method used to calculate working capital is often a source of disagreement. The governing agreement may require not only compliance with GAAP, but also consistency with the accounting practices historically used by the seller.
This issue was addressed by the Delaware Supreme Court in Chicago Bridge & Iron Co. N.V. v. Westinghouse Electric Co. LLC, 166 A.3d 912 (Del. 2017). In that case, the court emphasized that working capital calculations must follow the specific accounting principles and methodologies set forth in the purchase agreement, including any requirements for consistency with past practices.
In Chicago Bridge, the calculation of net working capital was central to the dispute. Shortly before closing, the seller calculated net working capital at more than $428 million above the target, but the calculation did not align with GAAP. After closing, during the true-up process, the buyer calculated net working capital—this time consistent with GAAP—at approximately $2 billion below the target. Litigation followed. Although the trial court ruled in favor of the buyer, the Delaware Supreme Court reversed that decision and sided with the seller, based on the language of the agreement.
Additional information about the decision is available from the Delaware Supreme Court’s published opinion: Chicago Bridge & Iron Co. N.V. v. Westinghouse Electric Co. LLC.
Reducing the Risk of Disputes
Working capital adjustment provisions can also help address concerns about potential manipulation of financial metrics. For example, a seller might accelerate collections or delay payments in an effort to increase working capital before closing. Clear drafting can reduce these risks by defining which accounts are included, specifying the applicable accounting principles, and establishing a process for post-closing review and dispute resolution.
Conclusion
Working capital plays a central role in APAs and SPAs by aligning the financial expectations of buyers and sellers. Clearly defining working capital, identifying the applicable accounting standards, and outlining adjustment and dispute resolution mechanisms can help reduce uncertainty and limit post-closing disagreements.
Beresford Booth’s Business, Mergers and Acquisitions Group regularly advises buyers and sellers on asset and stock purchase agreements that include working capital adjustment provisions. If you would like to discuss your transaction, please contact Beresford Booth at info@beresfordlaw.com or by phone at (425) 776-4100.
