Published April 06, 2011

Working Capital Adjustments

By Paul Wormley

In a Part II of the Anatomy of a Letter Intent post, I introduced Working Capital Adjustments as purchase price adjustments in small business acquisitions. Working Capital Adjustment are often a source of confusion in the sale of a small business.

A properly structured Working Capital Adjustment captures the performance (good or bad) of a business between executing a Letter of Intent (LOI) and closing an acquisition; it is not meant to benefit or penalize the seller or the buyer.

The most important component of a Working Capital Adjustment is the Working Capital Target. The Target is negotiated between buyer and seller as part of the LOI. It determines the 'appropriate' level of working capital to be delivered at closing & 'appropriate' meaning the amount of working capital required to operate the business. An 'appropriate' amount will be specific to each company and must take into consideration seasonality, growth, and a host of other factors.

If the Working Capital at Closing is more than the Target, more cash is due the seller. If the Working Capital at Closing is less than the Target, the cash due to the seller is decreased. But the net impact to buyer and seller will be zero.

A simple example will be help illustrate:

In the negotiation of an LOI a buyer and seller agree to set the Working Capital Target at $10 and the Working Capital is as follows:

Working Capital Adjustments Blog Post Image 1

At closing, the actual working capital of the seller's business is as follows:

Working Capital Adjustments Blog Post Image 2

Working Capital at Closing ($13) exceeds the Working Capital Target ($10) by $3 so the Seller receives an additional $3 at closing.

From LOI to closing, the seller's business grew and, as a result, the balance sheet of the business grew. Accounts receivable increased from $20 to $25, requiring the seller to fund $5 of cash into the business. The accounts payable also increased from $10 to $12, a source of $2 cash to the seller.  The net impact of the increase in accounts receivable (fund $5) and accounts payable (get $2) was $3 in cash funded by the seller into the business to support working capital growth.

The Working Capital Adjustment 'worked'. The net impact to the seller was $0 because the seller recaptures the $3 funded into working capital. The net impact to the buyer was $0 because the buyer paid an additional $3 for a balance sheet that was $3 larger than at LOI.

This example can obviously work in both directions but the outcome will be the same – neither buyer or seller will benefit or be penalized by the Working Capital Adjustment.

Paul Wormley - General Partner

Paul joined Hadley Capital in 2005. He has spent his entire career working with small and emerging companies. Paul grew up in a family business environment and is an owner of his family’s community newspaper business. Paul works with GT Golf Supplies, Pneu-Con, Open Sky Media and Centare. He was the chairman of the board of directors for i-deal Optics, a previous Hadley Capital company.

Paul is an outdoor enthusiast who enjoys fishing, hunting, riding motorbikes, Crossfit and an occasional craft beer. He works closely with a number of non-profit organizations including One Acre Fund and Trout & Salmon Foundation, and serves as chairman of the Finance Committee at his church.

Paul is a graduate of the University of Colorado at Boulder and received an MBA from the Kellogg School of Management at Northwestern University. He and his wife, Rosemary, have three children.