Purpose – a transaction price must be established long before closing day. This computation sets the required working capital balances (working capital peg) as of the day the purchase price is set. It creates a measurement method that is agreed to by all parties. It is objective and quantifiable which eliminates subjectivity and future disputes.
The concept is to define a net working capital amount that the seller is guaranteeing the buyer.
If the transaction is an asset sale the standard is that it is a cash free – debt free transaction. That means that the seller keeps all the cash of the company on closing day and the seller retains or pays off all of the debt of the company. Neither cash nor debt transfers to the buyer.
Example – projections to establish working capital peg
- AR 3,000,000
- Prepaid Assets 500,000
- Inventory 2,500,000
- Total Current Assets 6,000,000
- Accounts Payable 1,500,000
- Accrued Payroll 500,000
- Other Current Liabilities 500,000
- Total Current Liabilities 2,500,000
- Net Working Capital (A-L) 3,500,000
The accounting balances will change many times between the price lock date and the closing date. In fact, the accounting numbers will continue to change for months after closing with dates and events that affect the final balances.
Let’s assume a March 31 closing date. Vendor invoices will continue to come in for an extended time after March 31 that pertain to business conduct before March 31. If the selling company is on an accrual basis they may or may not have anticipated and accrued for these costs and expenses. Let’s assume that there was an accrual but it was deficient by 50,000.
Example assumes a final reconciliation and settlement date 120 days post-closing.
For simplicity let’s assume the Accounts Payable is the only change.
The total amount included in the working capital peg for accounts payable was 1,500,000. The actual number came in at 1,550,000 including the 50,000-overage amount. Under this outcome the seller owes the buyer 50,000 back. The buyer only agreed to accept 1,500,000 in liabilities and they ended up with 1,550,000. If the total had been 1,450,000 the buyer would have owed the seller an additional 50,000. The adjustment amount makes the excess or deficiency amount neutral for the buyer and the seller when contrasted to the measurement amount.
Here is an example that illustrates how the outcome could be manipulated by the seller.
Recall that the seller gets to keep all of the cash at closing. If the seller committed to providing 3,000,000 of AR and then the seller collected 500,000 early for any reason including favor from a friend, behind the scenes discount to pay early, etc. there would only be 2,500,000 of AR left for the buyer.
Without this adjustment concept the buyer would be out 500,000 upon prior settlement.
With this concept the outcome cannot be manipulated and it does not matter if the final AR number is 2,000,000 or 3,000,000. It will be settled based pm the 3,000,000 that was projected.
Bit of Advice - most attorneys do not understand this concept and they certainly cannot reduce it to writing. It is far better to keep the attorneys out of this one and for your M&A advisor to author a short description of this concept with concise examples for the purchase document.
The most important point is to make sure that your accounting records (balance projections) are accurate and may be relied upon. If they are this process will be economically neutral to you. If they are not accurate you are setting yourself up for an adjustment that might be favorable or unfavorable.
It is much more prudent to strive for no economic surprises!