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DealMakers - 2020 Annual


A day late and a dollar short

by Jaco Meyer and Rachel Kelly

Purchase price adjustments can take any number of forms, working capital adjustments being one of them.


Purchase price adjustments are commonly incorporated into M&A transactions. They are used to protect the buyer against value erosion or leakage in the target company or business, up to the closing date, to ensure that the seller maximises its position in the event of gains in the target company, and to remove the impacts of any unexpected events arising from the time that the parties agree the terms of their transaction to the time that the buyer takes over the business. Purchase price adjustments can take any number of forms, working capital adjustments being one of them.


The form of working capital adjustments are varied, and depend on what the parties have agreed. Some working capital adjustments are designed to strip out all cash from the business at the closing date, making it the responsibility of the buyer to provide cash injections from day one. In other cases, an adjustment will ensure that enough cash remains in the target to allow it to operate in the ordinary course of business, for a time, post-closing. There are also earn-out adjustments, which are often designed to compensate the seller, depending on the future value of the business.

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Jaco Meyer
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Rachel Kelly

Purchase price adjustments are often created on a "cash free, debt free"  basis, in which case the purchase price is adjusted at the completion of the transaction, to ensure that all excess cash, as measured over debt, accrues to the seller. An adjustment based on "target working capital", however this may be defined, seeks to ensure a level of working capital within the business at the closing date; if this working capital is not in place, the seller is required to "top up"  the business, usually by means of a reduction in the purchase price. The form of purchase price adjustments is also based heavily on the tax position of the parties, which must be considered. 

This article summarises how working capital may be calculated, common issues which arise with working capital adjustments and general considerations in ensuring the accuracy of working capital adjustments.

Calculating working capital
"Working capital"  refers to current assets, less current liabilities, and calculates the liquidity of a business. Current assets are those assets which are expected to be converted to cash within a period of one year and may include cash and cash equivalents, inventory, accounts receivable, deposits receivable and prepaid expenses. Current liabilities, on the other hand, are short-term financial obligations that are typically due within a period of a year, and could include short term borrowings, accounts payable, accrued expenses and taxes, payroll liabilities and accruals, dividends declared and not paid and "debt like items". Debt-like items are those items which may not strictly be debt but, in substance, represent short-term obligations which the buyer typically considers to be for the seller's account, such as the seller's transaction costs, deal bonuses and break costs.  The make up of a company's working capital will depend very specifically on that company, and so it is not possible to create a "one size fits all"  definition of working capital which will apply across the board. 

A working capital adjustment is typically designed to adjust the purchase price, either upwards or downwards, in accordance with the fluctuation in working capital from the time that the parties agree the terms of the transaction until the time that the transaction is implemented. If the actual working capital is higher than the target working capital, meaning that the company has more current assets or less current liabilities than anticipated, the purchase price is commonly adjusted upward on a Rand-for-Rand basis, for the seller's benefit. If the actual working capital is lower than the target working capital, the purchase price will be adjusted downward on a Rand-for-Rand basis and the buyer is compensated. There are, of course, a myriad variations to what the parties may agree. The parties may, for example, choose to cap the actual working capital at a certain amount – although this is prejudicial to the seller, unless a similar cushion is introduced in the event that the actual working capital is lower than anticipated – or provide that no adjustment will be made unless the difference between the actual and target working capital exceeds a certain amount.

Normalising working capital and avoiding double counting
In calculating target working capital, any unusual, non-recurring and non-operating amounts are typically excluded. Having regard to what should be excluded is especially important where the target operates in a cyclical industry, such as retail; is a party to any related party transactions; or is a subsidiary of another company, which absorbs its administrative costs. 

Another important consideration is to avoid double counting. Transaction advisers must ensure that the calculation of target working capital accords with the provisions of the acquisition agreement. For example, if the seller provided an indemnity against any particular liability and such indemnity is taken into consideration in the post-closing balance sheet, the seller may "pay" for the liability twice: firstly, in terms of the indemnity, and secondly, as part of a purchase price reduction.

The practicalities
An offer to acquire a business is typically made on the basis of the most recent audited financial accounts of the business. Following the implementation of the transaction, the parties and their accountants will prepare and agree further accounts as at the closing date, which then form the basis on which the adjustment is calculated. 

Key takeaways
Purchase price adjustments based on working capital considerations require detailed analysis and negotiation. It is suggested that the parties' respective legal and financial advisers be involved early on in the process to minimise the risk of mistakes and disputes.
It is also necessary for the acquisition agreement to be drafted in such a manner that it clearly defines key terms, and which includes a schedule of the accounting policies and procedures used in calculating the working capital of the target, along with a sample of such calculation. 

A purchase price adjustment can have a material impact on the ultimate consideration payable under the transaction. However, it is a necessary, and often fair, mechanism to ensure that the interests of both the buyer and the seller are protected. 

Meyer is an Associate and Kelly a Director at Cliffe Dekker Hofmeyr.

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