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Tips For Avoiding Post-Closing Working Capital Disputes | Law360


This article originally appeared in Law360.

by Sharon Bromberg, CohnReznick

Sharon BrombergThe merger and acquisition process is often complicated and fraught with risk for both the buyer and seller. When a buyer negotiates a purchase price for a target company, its valuation is based, in part, on the target’s historical financial performance. Typically many months pass between the date of the letter of intent (LOI) and the closing date of the transaction. Thus, most purchase agreements include a provision for a post-closing adjustment — or “true up” — of net working capital, which reflects changes in current assets and liabilities between the negotiated working capital expected to be delivered at closing and the actual working capital amount delivered at closing. In determining the final closing working capital, the buyer’s objective is to calculate as low as an amount as possible, while the seller’s objective is to show it as high as possible.

Unfortunately, the conclusion of a sales transaction sometimes precipitates the beginning of a lengthy dispute period, as contention arises around the accounting treatments used in calculating the actual working capital delivered at closing. Both parties can potentially side-step post-closing disagreements by paying very careful attention to calculations, definitions and methodologies, and making sure such accounting principles and practices are spelled out in the purchase agreement.

When it comes to purchase agreements, the devil is in the details. The use of precise language with respect to working capital protects buyers and sellers, therefore both parties should seek accounting expertise when drafting the working capital sections of the purchase agreement and determining the appropriate definitions, methodologies and calculations used to perform the true-up. The importance of this should not be underestimated, as there is a high degree of complexity involved in determining net working capital and significant potential for disagreement around the buyer’s and seller’s interpretation of the definitions and application of accounting methods used to arrive at the post-closing true-up.

A post-closing working capital true-up hinges on the agreed-upon definition of current assets and liabilities. Under U.S. generally accepted accounting principles (GAAP), working capital is calculated as current assets less current liabilities. In the context of an M&A deal, current assets typically include accounts receivable, prepaid items and inventory. Current liabilities include accounts payable and accrued expenses.

While no standard provision exists to calculate the true-up, the process usually begins with establishing the target working capital amount. The target working capital balance is typically based on an average of a 12-month period. It may be adjusted to exclude certain assets and certain liabilities, such as deferred taxes, sales tax and related-party balances. This target working capital balance is compared to the actual working capital amount as of the closing date and the purchase price is adjusted up or down based on the difference.

The application of accounting principles and practices to determine the target and final working capital balances is where things get tricky, sometimes resulting in contentious issues between the buyer and seller. What assets and liabilities are included in the computation? What is excluded? Were GAAP principles or another acceptable accounting method consistently applied in determining the target and final working capital balances? What happens when a consistent application of an accounting principle is not deemed to be GAAP? What is the difference between the consistent use of an acceptable accounting treatment and a preferable accounting treatment? Should interim or year-end accounting principles historically used by the company be applied? Has the classification of an asset or liability changed as a result of an intervening event or business development? Anticipating these and other such questions while drafting the purchase agreement will eliminate, or at least minimize, disagreements in connection with the final working capital calculation. As stated earlier, an accounting expert can advise in the use of precise language in the purchase agreement. The key is to be as clear and thorough as possible in the language and thereby close the door to ambiguity.

With that said, there are several areas that require special consideration, including accounts receivable, inventory and contingent liabilities. Any working capital component that involves an estimate can be problematic, and often these issues do not rise to the surface during the drafting of the purchase agreement.

Accounts receivable and inventory are two of the largest components of current assets typically included in the calculation of working capital. Determining the valuation methodology for accounts receivable is an important consideration. Typically, a business will carry a reserve for doubtful accounts, but the methods employed for including accounts in the reserve can significantly differ. A buyer needs to understand the methods the seller used to determine its historical accounts receivable reserve, and this methodology needs to be consistently applied in calculating the closing working capital. In certain instances, agreeing to a formula or a fixed amount upfront may avoid working capital disputes later.

With regard to inventory, will a physical inventory be conducted at the time of closing? If the seller has used a perpetual system to determine inventory, is the buyer comfortable with the accuracy of the seller’s methodology and is it possible to roll the inventory forward from the last physical count? Not taking a physical inventory at closing is risky and without being able to rely on a perpetual system or roll-forward procedures, discrepancies may be identified that were not identified during the diligence process.

The methodology used to value inventory should also be spelled out on a schedule to the purchase agreement, whether LIFO (last-in, first-out) or FIFO (first-in, first-out), lower of cost or market. For example, in negotiating the specifics of the working capital calculation, consideration should be given to the potential impact of a LIFO reserve account on the working capital calculation in an inflationary environment. Will cost of goods sold increase, thereby reducing earnings and profits?

Another key consideration is determining the inventory reserve for obsolescence, which is very subjective. Similar to the reserve for doubtful accounts, in certain instances, agreeing to a formula or a fixed amount upfront may avoid working capital disputes later. Clearly, an understanding of the industry is needed to determine the appropriate reserve.

When considering a contingent liability, the question is whether the criteria have been met to record it as such. For example, if a minimum purchase requirement was not met, when is it appropriate to record the accrual for the liability? In a litigation matter, is the litigation far enough along where a settlement amount can be determined that is probable and estimable?

In order to accrue a contingent liability, the amount needs to be estimable and payment of that liability needs to be probable. Per GAAP, contingent liabilities can be categorized in three ways based on the likelihood of those liabilities actually occurring. A "high probability" contingency is a liability that is both probable of actually occurring and one where the costs can be reasonably estimated.

These examples are illustrative of the intricacies involved in determining the net working capital balance. Buy-side and sell-side due diligence is often not enough to anticipate the accounting nuances that surface during the negotiation of a purchase price, thus it is critical to seek accounting advice when drafting the purchase agreement. The accounting language needs to be as specific and unambiguous as possible, or else both parties should prepare themselves for a lengthy dispute process.

In the final analysis, true-ups of working capital provide confidence to buyers that they will have adequate working capital to meet the immediate needs of the business, including commitments to customers and creditors, and are able to operate into the future. Sellers want to be appropriately compensated for the business assets, earnings and profits that they had a hand in building. Carefully worded purchase agreements will help avoid disputes and assist buyers and sellers in achieving their respective goals.

Sharon Bromberg, CPA, is a partner in CohnReznick’s Edison, New Jersey, office. She has more than 20 years of experience providing transaction advisory and M&A consulting services.

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