Deal Essentials: Working Capital Considerations for a Successful Transaction

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1 Deal Essentials: Working Capital Considerations for a Successful Transaction Jonathan Stevens, Baker & McKenzie, New York Nick Marchica, Baker & McKenzie, New York Margaret Hanson, Axis Capital Baker & McKenzie LLP is a member firm of Baker & McKenzie International, a Swiss Verein with member law firms around the world. In accordance with the common terminology used in professional service organizations, reference to a "partner" means a person who is a partner, or equivalent, in such a law firm. Similarly, reference to an "office" means an office of any such law firm Baker & McKenzie LLP

2 Working Capital: Where to find it? Provision in a Stock Purchase Agreement, Asset Purchase Agreement or Merger Agreement that provides for an adjustment to the purchase price to reflect changes in the financial condition of the target business of an agreed economic measure on the one hand and the actual closing date value of that economic measure Baker & McKenzie LLP 2

3 Working Capital: Where to find it? (example) The total price for the Shares to be paid by the Buyer to the Seller is : the Purchase Price plus a sum equal to the Cash; minus a sum equal to the Indebtedness; plus an amount by which the Working Capital exceeds the Target Working Capital or minus a amount by which the Working Capital falls short of the Target Working Capital minus other negotiated adjustments such as unpaid transaction expenses, taxes for pre-closing periods, capex target, etc Baker & McKenzie LLP 3

4 Working Capital: Why do we have it? Used where fundamental agreement as to purchase price but there is going to be a gap between signing and Closing Buyer conducts financial due diligence and arrives at purchase price on specific set of historic financial statements Last audited financial statements, or More recent unaudited financial statements Bridges gaps and allows Buyer to receive the balance sheet it bargained for 2016 Baker & McKenzie LLP 4

5 Working Capital: Why do we have it? (cont d) Prevents fluctuations in value by Seller s operation of business before closing that could include: Stretching payables Accelerating receivables Delaying CapEx Selling inventory without replacement Distributing Cash out Creates possibility of post-closing accounting judgments to adjust price Provides Buyer with enough working capital to run acquired business without injecting additional capital 2016 Baker & McKenzie LLP 5

6 Working Capital: What is it? Working capital definitions are not one size fits all In a typical share purchase transaction working capital is defined as: Cash, marketable securities, inventory and accounts receivable less current accounts payable and other current debt What other balance sheet items could be included? How would working capital definitions differ in an asset purchase transaction? 2016 Baker & McKenzie LLP 6

7 Working Capital: When is it measured? Working capital is a static balance sheet measurement, not an operating measurement. Working capital calculations and agreement on the amounts can take place months after closing Working capital items may require measurement immediately at Closing How is working capital addressed in a transaction with multiple closing dates? 2016 Baker & McKenzie LLP 7

8 Working Capital: Who are the stakeholders? Corporate Finance Treasury Accounting Operations Legal Tax 2016 Baker & McKenzie LLP 8

9 Working Capital: How is it accounted for? Adjust estimated working capital after Closing by reference to actual position at Closing: Target working capital negotiated 3-5 days prior to closing, Seller provides estimate of WC Buyer, days post-closing, calculates adjustment (up or down) Sellers reviews Buyer s adjustment calculation and either agrees or disagrees if agreement, adjustment payment by Buyer or Seller If disagreement, accountant reviews the two calculations and decides who is correct 2016 Baker & McKenzie LLP 9

10 Working Capital: Key Items Negotiated Target working capital amounts / items included Preparation of Closing Date Statements Month-end? Who prepares, Buyer or Seller? Choice of accounting methods Foreign currency exchange rate Choice of independent auditor / dispute resolution Liability for cost of independent auditor Caps and deductions including treatment of trapped cash 2016 Baker & McKenzie LLP 10

11 Working Capital: Common Items Disputed Inventory obsolescence Doubtful accounts receivable Contingent liability estimates Warranties/returns Offset, e.g. of related under- and over-accruals? 2016 Baker & McKenzie LLP 11

12 Working Capital Alternative: Lock Box Purchase price calculated by reference to balance sheet dated to signing the locked box date Price is therefore fixed with no post-closing adjustments Buyer must rely on indemnification for protection More common outside of the U.S Baker & McKenzie LLP 12

13 Working Capital Alternative: Lock Box (cont d) From the Buyer s perspective: Must conduct extensive financial diligence, especially if balance sheet is unaudited Will request undertakings from Seller that business has been conducted in the ordinary course from the locked box date Target performance in period between locked box date and closing date should be predictable and not volatile Potential upside / downside transfer to purchase as of locked box date rather than closing date 2016 Baker & McKenzie LLP 13

14 Working Capital: Accounting for Payment Mechanics for payment Escrow Holdback Impact on Purchase Price Allocation Coordination with indemnity provisions 2016 Baker & McKenzie LLP 14

15 Working Capital: Key Takeaways NOT boilerplate-significant scope for post-closing dispute that could affect economics of the transaction Cross-functional team needs to review and clearly understand the language and mechanics of working capital provisions Agreement to process and procedures up front will save time and expense Post-Closing 2016 Baker & McKenzie LLP 15

16 Working Capital: Deal Case Study #1 Is Buyer allowed to take post-closing events into account when calculating a purchase price adjustment? Facts: $200k accrual taken in closing date balance sheet, which is accurate based on facts known that day As a result of new facts that emerged post-closing, Buyer calculates accrual to be $1m Which number should be used? Seller: only use information available on date of preparation of closing date balance sheet Buyer: seeks flexibility and takes risk that additional information could either increase / decrease purchase price 2016 Baker & McKenzie LLP 16

17 Working Capital: Deal Case Study #2 What happens if there is significant currency fluctuation? Facts: Target operates in several Latin American countries Reserves in balance sheet were calculated in local currency Post-closing, significant movement in exchange rates All amounts under contract to be paid in US dollars Which rate should be used? 2016 Baker & McKenzie LLP 17

18 2016 Baker & McKenzie LLP 18