Читать книгу M&A Disputes - Biemans A. Vincent - Страница 16

At a basic level, a company's net working capital is the difference between its total current assets and its total current liabilities. In summary, current assets are cash and other assets that are reasonably expected to be realized in cash, sold, or consumed during the normal operating cycle of the business.2 Current assets include items such as accounts receivable, inventory, and prepaid expenses. Similarly, current liabilities include short‐term liabilities such as accounts payable, accrued liabilities, and the current portion of long‐term debt. In essence, net working capital is the short‐term capital available to be used by the business in its day‐to‐day operations.

For purposes of many valuation analyses, the analyst considers whether the company has sufficient working capital to operate its business. If the company has a shortfall of or excess working capital, an adjustment needs to be made to the value of the company. Such adjustments can have a dollar‐for‐dollar impact on the valuation.

Example: Comparative Valuation Impact

◼ Company A and B are identical. Company A has sufficient working capital to operate its business (no excess or shortfall). Company B has the same amount of working capital and in addition has a bank account with $1 million in surplus cash (i.e., excess working capital).

◼ The value of Company B is $1 million higher than Company A as the buyer could buy Company B, extract $1 million, and end up with the same company as if the buyer had purchased Company A.

◼ Note: The example is simplified and ignores possible complications such as adverse tax effects. Moreover, excess cash is – in practice – not necessarily transferred with the company but may be extracted by the seller prior to closing.

NET WORKING CAPITAL ESTIMATION AND ADJUSTMENT

On the date the transaction is closed, neither the seller nor the buyer can necessarily precisely determine the amount of net working capital that is transferred with the business. Even if the closing date were at the end of a quarter or fiscal year, which is typically not the case, not enough time would be available to go through the regular end‐of‐period closing of the books.

As the company uses its working capital to operate its business (e.g., during the months prior to the closing date), the composition and amount of the company's net working capital is subject to continuous change. Indeed, every sale, purchase, and payment as well as the simple passage of time can result in changes to the composition and/or amount of the company's net working capital. Moreover, the company's accounting for many transactions and various elements of net working capital are normally not in real‐time. Rather, the company's accounting naturally lags behind the underlying events, only recording certain events at the end of the day, week, month, or reporting period. While some events can be recorded in the company's books in (near) real‐time, other accounting items can generally not be finalized until the company closes its books for the relevant period.

Transaction parties vary in their approach to selecting the preliminary amount of net working capital that is utilized to determine the purchase price to be paid at closing. On the one hand, some purchase agreements simply contain an agreed‐upon amount that was determined some time prior to closing. At the other extreme, some agreements have an elaborate pre‐closing estimation procedure that involves a proposed amount of net working capital to be used at closing, objections thereto, and even pre‐closing dispute resolution procedures. Most agreements, however, fall somewhere in between these two extremes. The transaction is often closed using a purchase price amount based on the estimated net working capital at closing, a target amount of net working capital, or an otherwise agreed‐upon amount. We discuss the determination of the target net working capital in Chapter 6.

After the closing, the amount of net working capital that was transferred with the company can generally be determined more precisely as opposed to being estimated without the benefit of typical closing of the books procedures. Notwithstanding any dispute related to the determination of the net working capital, once the net working capital is determined post‐closing, the purchase price can be adjusted and a payment made between the parties, if any, to close out the transaction. There are three common elements to this net working capital true‐up process (barring a dispute):

1. The target net working capital, which is part of the agreed‐upon purchase price for the transaction. In other words, if the final net working capital is the same as the target net working capital, the final purchase price equals the originally agreed upon purchase price amount.

2. The estimated or preliminary amount of net working capital as of the closing date. The amount to be paid as of the closing date is calculated based on this preliminary amount, which can be different than the target net working capital and may result in a preliminary purchase price adjustment at closing.

3. The post‐closing calculation of the final net working capital as of the closing date, which is determined after the fact and based upon which the final purchase price is determined.

The adjustment of the purchase price is commonly dollar‐for‐dollar. In other words, a one‐dollar difference between the preliminary amount based upon which the transaction closed and the final net working capital amount that is determined after the fact, results in a one‐dollar purchase price adjustment (relative to the amount paid at closing). The following is an example of this process.

Example: Adjustment Arithmetic

◼ The seller and the buyer agree to transact a company for a purchase price of $100 million, including a target amount of net working capital of $10 million.

◼ Prior to closing, the seller and the buyer agree on an estimated amount of net working capital for purposes of closing the transaction in an amount of $8 million.

◼ On the closing date, the buyer pays seller $98 million, which is calculated: $100 million (purchase price) – $10 million (target net working capital) + $8 million (estimated net working capital).

◼ After closing, the actual net working capital turns out to be $11 million. The purchase price is adjusted to $101 million, which is calculated: $100 million (purchase price) – $10 million (target net working capital) + $11 million (actual net working capital).

◼ The buyer makes an additional payment of $3 million, which is calculated: $101 million (final purchase price) – $98 million (paid at closing).

The above implementation of a dollar‐for‐dollar impact starting with the first dollar does not always apply. For example, some purchase agreements contain a minimum threshold below which no purchase price adjustment takes place. The applicable purchase agreement includes the relevant provisions that may specify a minimum threshold or other custom mechanics applicable to the agreed upon post‐closing net working capital–based purchase price adjustment.

AN APPROACH TO DEFINING AND QUANTIFYING NET WORKING CAPITAL

To determine the final amount of net working capital that was transferred with the business as of the closing date, the parties need to have defined net working capital and selected an approach to quantifying it. Three general contractual approaches are to determine the amount of net working capital (i) in accordance with U.S. GAAP, (ii) in accordance with the company's historical accounting practices, or (iii) in accordance with the company's historical accounting practices consistent with GAAP, GAAP as applied consistently with the company's historical accounting practices, or a similarly worded arrangement. We use the shorthand “past practices in accordance with GAAP” for the third approach throughout this book. We also generally use “GAAP” as shorthand for U.S. GAAP.

All three methodologies (and a variety of other methodologies) can be encountered in practice. In our experience, past practices in accordance with GAAP is a very common general approach. Utilizing past practices in accordance with GAAP as the methodology for determining the amount of net working capital generally has important advantages over the other two methodologies. Although, the formula can be customized with, for example, carve‐outs and prescribed measurement methodologies for specific items, it does not require the parties to negotiate the quantification of the individual components of net working capital. Moreover, the company already tracks and quantifies its current assets and liabilities as part of its regular accounting, which typically should be in accordance with GAAP. In addition, the target net working capital – to which the closing date net working capital is compared – is commonly determined based on the company's historical accounting practices. In other words, utilizing past practices in accordance with GAAP provides for a comprehensive and objective framework that is – or at least should be – already in use by the company.

In many situations, the formula would falter without both of its book‐ends (i.e., past practices and GAAP). Excluding the context of the company's historical accounting practices and simply prescribing in accordance with GAAP as the methodology for the proposed closing statement often insufficiently narrows possible outcomes. GAAP by itself is not narrowly prescriptive on many accounting topics. Rather, it provides companies with many acceptable accounting choices across various assets and liabilities to allow the company to tailor its accounting to its specific facts and circumstances. Including the company's past practices incorporates the accounting choices as the company has historically made them and thus narrows the possible outcomes. It also increases comparability with historical financial information, including the basis on which the target net working capital was derived.

Eliminating GAAP from the equation and having the closing statement prepared in accordance with past practices should in many instances greatly concern the buyer. The seller may have historically implemented non‐GAAP compliant accounting practices that would then – pursuant to the purchase agreement – be used to determine part of the purchase price. Without the contractual requirement that those past practices comply with GAAP, the buyer may be exposed to an unexpected and disadvantageous purchase price adjustment without a contractual basis to challenge the additional payment. The buyer is typically not in a position to verify that net working capital is accounted for in accordance with GAAP until after the transaction has closed.

Although, there is a place for other formulas – and again they are used in practice – utilizing the formula of past practices in accordance with GAAP can be a comprehensive and appropriate basis for calculating net working capital. Notwithstanding, that formula certainly does not eliminate all potential issues. There are a variety of issues and ambiguities that can occur and lead to disputes between the parties when utilizing past practices in accordance with GAAP. We discuss the concept of past practices in accordance with GAAP and some of its potential limitations more extensively in Part 2 of this book.

THE DEMARCATION AND QUANTIFICATION OF NET WORKING CAPITAL

Net working capital is comprised of a set of balance sheet accounts, namely current assets minus current liabilities. In considering each potential component of net working capital, there are three questions to be answered:

1. Should a particular item be included on the balance sheet or not? In accounting terms, this question relates to “recognition.”

2. If it is to be included on the balance sheet, should a particular item be considered a current or a non‐current asset or liability? In accounting terms, this question relates to “classification.”

3. If an item is to be included as a current asset or current liability on the balance sheet, the remaining question is: for what amount? In accounting terms, this question relates to “measurement.”

In addition, there is often a fourth question that needs to be asked in the context of a purchase price adjustment:

4. Are there any (partial) contractual exceptions or customizations to the determination of net working capital that deviate from past practices in accordance with GAAP? The purchase agreement can provide for a variety of customizations and contractual limitations. For example, the purchase agreement can provide for items to be included with or excluded from net working capital that would otherwise be treated differently under GAAP.

2

See FASB ASC Master Glossary, at Current Assets.