WORKING CAPITAL - How to Deal with Working Capital when Purchasing a Business

December 2007

Although the Working Capital adjustment can be a material component of the total purchase price of a business, the mechanics of calculating this adjustment are often misunderstood and can create unnecessary tension between Buyer and Seller.

It is our belief that the Working Capital adjustment should be a "two way" adjustment which compares the actual Working Capital delivered at closing to a "Target" Working Capital amount. The Target should be sufficient to sustain the earnings level of the business being acquired (i.e. trailing twelve month average).

The objective of the Working Capital adjustment is to smooth out the economic impact of seasonality on the Target Company's business. If structured properly, the net purchase price proceeds to the vendor of the business should be the same no matter what time of year the business is sold.

To accomplish this objective, we have developed Do's and Don'ts with respect to how Working Capital should be determined.

Do
1.	Set the expectation of sufficient level of Working Capital at the Letter of Intent stage. This means clearly setting out the "mechanics" of the adjustment.
2.	Clearly define the components of Working Capital and clearly define what will be excluded from the definition of Working Capital. Working Capital is not a "defined" term under GAAP, so be clear on what your definition is, and tailor it to the Target Company being acquired.
3.	A projected calculation of the proposed Working Capital adjustment. Buyer and Seller should be clear on how the adjustment is calculated and what the amount of the adjustment could be.

Don't
1.	Leave the definition of the Target Level of Working Capital as a post Letter of Intent agenda item. This only defers the problem.
2.	Put limits on the amount of the Working Capital adjustment. This could lead to an unintended result of one party "winning".
3.	Use arbitrary Working Capital ratios. They need to be based on the actual Working Capital needs of the Target Company.

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