Working Capital Adjustment in a Merger Agreement: What You Need to Know

A working capital adjustment is a common feature of merger agreements. It is a tool used to ensure that the purchase price of a company reflects the actual value of its assets and liabilities at the time of the acquisition. In this article, we will explore the ins and outs of working capital adjustments in merger agreements.

What is Working Capital?

Working capital is the money a company has available to cover the cost of its day-to-day operations. It is calculated as the difference between a company`s current assets (cash, accounts receivable, inventory, etc.) and its current liabilities (accounts payable, accrued expenses, etc.).

Why is Working Capital Important in a Merger Agreement?

In a merger agreement, the buyer typically agrees to purchase the seller`s assets or shares for a set price. However, if the seller`s working capital is higher or lower than expected at the time of the acquisition, it can result in a significant difference in the purchase price.

To avoid this problem, a working capital adjustment is added to the merger agreement. The adjustment is designed to ensure that the purchase price reflects the actual value of the assets and liabilities at the time of the acquisition.

How Does a Working Capital Adjustment Work?

A working capital adjustment is typically calculated as the difference between the estimated working capital at the time of the acquisition and the actual working capital at closing. If the actual working capital is higher than estimated, the purchase price is increased. If it is lower than estimated, the purchase price is reduced.

For example, if the purchase price for a company is set at $10 million and the estimated working capital is $2 million, the total price would be $12 million. However, if the actual working capital at closing is only $1 million, the purchase price would be reduced to $11 million.

What Should You Consider When Negotiating a Working Capital Adjustment?

When negotiating a working capital adjustment, it is important to consider the following factors:

1. How will working capital be defined and calculated?

It is important to agree on a clear definition of working capital and how it will be calculated. This can include which assets and liabilities are included in the calculation and any adjustments that may need to be made for non-recurring items.

2. What is the target working capital?

The target working capital is the estimated amount of working capital at the time of the acquisition. It is important to agree on this amount as it will impact the final purchase price.

3. What is the adjustment mechanism?

The adjustment mechanism outlines how the adjustment will be calculated and when it will be paid. This can include the use of a third-party arbitrator to resolve any disputes.

In conclusion, a working capital adjustment is an important tool used to ensure that the purchase price of a company reflects the actual value of its assets and liabilities at the time of the acquisition. When negotiating a working capital adjustment, it is important to consider the definition of working capital, the target working capital, and the adjustment mechanism. By doing so, both parties can ensure a successful merger agreement.