Working capital adjustments have evolved. No longer are they merely a means of addressing the pricing challenge posed by cash-flow volatility in the target business. Today they are used to determine the final purchase price. The first half of this post addresses the calculation of working capital and suggests some key questions to ask when drafting these clauses. In the second half, we look at issues relating to disputes arising out of working capital adjustments and provide a list of best practices when negotiating these clauses.

The Evolution of Working Capital Adjustments

Historically, the purpose of the working capital adjustment was typically to ensure that the acquired business came with just enough cash to carry on with its ordinary-course operations in the immediate post-closing period. In this form, working capital adjustments are a two-way street: in addition to ensuring that the purchaser does not have to inject new capital to the business just to keep it running, they also help to ensure that the purchaser does not receive an unbargained-for windfall if there happens to be an excess of cash in the business at the time of closing. By allowing the parties to “wait and see” how much working capital the business actually has at the time of closing, rather than forcing them to try to agree on an estimate of that amount in advance, the working capital adjustment mechanism also had the advantages of reducing transactional costs and allowing some transactions to move forward than might otherwise have stalled over this issue.

The efficiency and potentially broader applicability of this approach did not go unnoticed. Parties to transactions soon began to use working capital adjustments to deal with other types of transactional uncertainty. In today’s competitive deal environment, where purchase prices are often established before due diligence is complete (e.g. during an auction process), working capital adjustments often function as a means of determining the final purchase price, rather than merely as a means of adjusting the price up or down to compensate for mostly minor deviations in the cash position of the target business at the time of closing.

Calculating Working Capital


“Working capital” is broadly defined as current assets less current liabilities:

  • “Current assets” are those assets which are turned into cash within a period of one year. Examples include:
    • Cash and cash equivalents;1
    • Inventories;
    • Accounts receivable; and
    • Prepaid expenses (often limited to those that are of ongoing benefit to the buyer).
  • “Current liabilities” are those liabilities which are due within a period of one year:
    • Short-term debt;
    • Accounts payable; and
    • Accrued liabilities or “reserves”.

While the formula can be stated simply as “current assets less current liabilities”, capturing the parties’ exact intentions with an effective working capital provision can be a challenge.

The working capital target

The working capital target, a central concept in the working capital calculation, is an estimate typically based on normalized2 historical averages for the date of closing. After closing (usually within a specified period, e.g. 60 or 90 days), the purchaser must produce a finalized calculation of the actual working capital on the closing date, which will be normalized in the same manner as the target. The difference, if any, between this finalized calculation and the target will generally determine the amount of the working capital adjustment as well as its beneficiary.3 Working capital adjustments are usually, but not always, two-way adjustments and sometimes have a band or minimum that must be met before an adjustment is payable.

Questions to ask

Working capital calculations can be complex, in part because they need to reflect the particular situation to which they are going to be applied. Drafting an effective working capital provision will therefore typically require counsel and their clients to think carefully about questions such as the following:

What should be excluded from the working capital calculation?

It is important to ensure that items are not included under “current assets” and “current liabilities” if they were intended to be dealt with separately elsewhere in the purchase agreement. Suppose, for example, that in an asset purchase transaction, the buyer is not assuming accrued employment obligations, such as vacation pay, at closing. In that case, those items should not be listed as “current liabilities” for working capital purposes, as the seller could otherwise end up “compensating” the buyer for obligations that the buyer hasn’t actually assumed. The same will often be true of ongoing litigation costs and accrued tax liabilities where these are dealt with independently in the agreement.

In short, understanding the interaction of the “working capital” definition with other provisions of the agreement will often be an important prerequisite to a successful agreement (the Brim Holding case, discussed below, is a good example of how the interaction of the working capital provision with other provisions can lead to unintended consequences). To minimize disputes over which items do and do not form part of the working capital calculation, parties may wish to include an illustrative calculation that sets out all items to be included and which notes any adjustments that the parties intend to make to standard accounting principles.

What is the “ordinary course” of the business?

At the time of negotiating the term sheet, parties may have very different ideas about the appropriate amount of working capital for the business. A potential purchaser of an early-stage business may envision operating with a relatively high level of working capital in order to take advantage of growth opportunities, while the seller may have been operating the very same business on a shoestring “working capital” budget. To put it another way, the purchaser may consider the “ordinary course” of the business to be a course of growth (with the regular investment that that entails) while the seller is thinking of it as a course of stability (with investment in growth being exceptional and reliant on funds outside the scope of “working capital”). Each party will want to ensure that the agreement adequately reflects its understanding of the term “ordinary course” with respect to the target business.

What should the “normalization” encompass?

Another significant issue in calculating the target is what should and should not be normalized. To take a step back, “normalizing” generally refers to the adjustment of working capital to reflect items such as the following:

  • Head office charges (where the company being sold is a subsidiary of a larger enterprise);
  • Non-arm’s length contracts or employment relationships;
  • Accruals for liabilities, aged inventory or receivables;
  • Insurance premiums or other prepaid accounts;
  • Matters dealt with elsewhere in separate provisions or indemnities in the purchase agreement; and
  • Matters disclosed in due diligence or in schedules to the purchase agreement.

Retail and other businesses with significant seasonal or cyclical changes in working capital may also require special mechanisms to address the period in which closing will occur, so as to ensure that neither side ends up with a windfall solely because of the time of year in which the deal happens to close. Such considerations underscore the key point, which is that definitions relating to working capital should be appropriately tailored to the specific business being sold or purchased.

Consistency of the calculations

A number of “consistency” issues can arise when dealing with working capital adjustments. The post-closing working capital calculation should be consistent with the pre-closing “target” calculation from the standpoint of the assumptions and accounting principles that underlie the two calculations.

Dealing with zero balances

One consistency issue can arise out of the reference balance sheet, which document is often attached as a schedule to the working capital adjustment provision. While including such a balance sheet usually helps to ensure consistency in calculations, it is important to include all line items with respect to which an adjustment may be expected, even those that may show a zero balance at the time the target is calculated. Otherwise, a dispute may arise over whether those items were intended to be excluded altogether or whether they were left out only because they happened to have a zero balance at the time the target was calculated.

Consistency of accounting standards

A second issue is whether the balance sheet must be consistent with GAAP and/or consistent with previous audited statements of the target company – and which should govern in the event of a conflict. Wide variations can be found within GAAP-compliant approaches, and therefore merit some consideration. It is also prudent to consider the representations and warranties or indemnities surrounding GAAP compliance that may be applicable to your transaction and perhaps also to the reference balance sheet to ensure that there is no double counting or overlap. The Alliant Techsystems case discussed below is an example of what can happen when deal documentation leaves room for disagreement about the applicable accounting standard.

Resolving (and Avoiding) Disputes

Arbitrators, experts or judges?

Many working capital dispute mechanisms contemplate the use of a third-party to resolve any dispute that the parties are unable to resolve themselves. The third party will generally be called upon to act in one of two roles, as an arbitrator or as an expert. The difference is significant: an arbitrator typically asks each side to present its arguments and then selects a “winner”, while an expert typically asks each side to present its arguments, and then arrives at a resolution that may incorporate some or all of the positions of each party as well as the expert’s own ideas.

In our experience, parties to working capital disputes often take very one-sided approaches, so an expert’s determination may end up being more equitable than an arbitrator’s choice that is limited to an “either-or” selection between two starkly opposed positions. Some parties agree to put a “collar” around the dispute, requiring the expert to decide only within the range of values that have been proposed by the parties. Another consideration may be the location of such dispute resolution discussions. Specifying a particular office location of the independent third-party expert may help to avoid lengthy travel times and to ensure that your dispute is resolved by those familiar with the practices of your jurisdiction or industry.

An arbitrator may be more appropriate in circumstances where consideration of matters beyond those of a purely accounting nature may be required, including matters of contractual interpretation. The Alliant Techsystems case discussed below illustrates the importance of being specific about the types of issue that are eligible for resolution by an expert (who in that case, as is typical, was an accountant). At a slightly higher level, where an agreement does not clearly distinguish the types of dispute that are to be decided by a third party (whether arbitrator or expert) from those that are to be decided in the courts, significant disagreements may result. As both Alliant Techsystems and the NOV Enerflow ruling (also discussed below) show, this type of disagreement can be particularly difficult to resolve where the alternative resolution procedures entail dramatically different compensation consequences.

Illustrative case law

Disagreements relating to working capital are usually resolved without litigation, but those that have ended up in court can provide valuable lessons to counsel and businesspeople alike.

Inconsistency of final working capital number vs. target amount leads to major purchase-price reduction

Without ensuring consistency of the final working capital number with the target amount, the accounting classification of an asset could be affected by intervening events, resulting in a different treatment in the reference balance sheet than applies in the final statement. An example of this can be found in Mehiel v. Solo Cup Company (2007 WL 901637 (Del. Super. Ct. May 26, 2007)), where the merger agreement had a post-closing adjustment for working capital, with an arbitrator to resolve disputes. At issue was a real property asset with a value of $5.6m that had been treated as a current asset at the time of the negotiation of the target amount, due to the fact that the facility was up for sale. The buyer argued that the facility should be a long-term asset and excluded from working capital, a position with which the arbitrator agreed (and which the court subsequently declined to review). As a consequence, the buyer received a $5.6m reduction to the purchase price while retaining the real property – a significant win. This illustrates the importance of ensuring that the calculation of the estimated and actual working capital is grounded in consistent calculation metrics.

Double recovery allowed because parties’ agreement supported it

As discussed above, it is important not to draft a working capital provision in isolation. The interplay of the provision with other provisions of the purchase agreement should always be considered, with particular regard to the possibility of “double counting”. In Brim Holding Company, Inc. v. Province Healthcare Company (2008 WL 2220683 (Tenn. Ct. App. May 28, 2008)), Brim Holding Company, Inc. acquired Brim Healthcare, Inc. from Province Healthcare Company. The seller agreed to indemnify the purchaser for a piece of outstanding litigation. The purchaser paid $50,000 to settle the litigation, and demanded that amount under the indemnity. However, the seller had included a $50,000 reserve in the balance sheet for the litigation and therefore defended the claim on the basis that the amount had already been covered. While agreeing that the seller’s approach was logical, the court found that the documents supported the double recovery as the indemnity was drafted to cover all damages and not just for any amount not otherwise reserved.

Working capital adjustment time limit did not preclude purchaser from suing under indemnity

In a case with some parallels to Brim Holding Company, an Alberta judge’s ruling on an application to amend pleadings suggests that the existence of a working capital adjustment mechanism will not always preclude a plaintiff from seeking an alternative remedy, even where the mechanism is specifically time-limited and that time has expired. In NOV Enerflow ULC v. Enerflow Industries Inc., 2015 ABQB 759, the purchaser’s post-closing review of the acquired company’s books supposedly revealed that certain representations and warranties in the Purchase and Sale Agreement (PSA), relating to inventory and purchase commitments, were inaccurate. The vendor responded that, because the period specified in the PSA for objecting to its working capital and inventory calculations had expired, the purchase price could not be adjusted. The application judge agreed, but held that this was only the beginning of the analysis. In his opinion, because the PSA provided for recovery of “Indemnified Losses” – which included “all losses, costs [etc.] and other Liabilities whatsoever” resulting from a breach of a representation or warranty – it was at least arguable that, at trial, a court could award damages for any losses that had resulted from misrepresentations of the type that had allegedly occurred. Crucially, the application judge did not accept the vendor’s contention that such an award could only be understood as a purchase price adjustment. To the contrary, he held that it could “only be meaningfully described as damages” even if it were to be calculated with the purchase price as a reference point. As a consequence, the judge permitted the purchaser to amend its pleadings to include the claim in damages.

Working capital dispute resolution process governed dispute over correct accounting method

In Alliant Techsystems, Inc. v. Midocean Bushnell Holdings L.P., C.A. No. 9813-CB (Del. Ch. Apr. 24, 2015), the Delaware Court of Chancery was asked to decide whether a dispute over accounting standards should be resolved (a) under the price adjustment dispute resolution mechanism, which referred disputes to a third-party accountant, or (b) by means of a contractual remedy in damages under the indemnity provisions of the agreement, which was a court-based remedy. The dispute arose when, in its 60-day post-closing calculation of “Net Working Capital”, the purchaser used a different accounting method than the seller had employed in its good-faith pre-closing estimate. As a consequence, what was to have been a $4m adjustment in the seller’s favour was transformed into a $22m adjustment in the purchaser’s favour (as measured against the $188m target in both cases).

According to the agreement, the Net Working Capital calculation was to be performed:

…in accordance with GAAP and otherwise in a manner consistent with the practice and methodologies used in the preparation of [the most recent financial statements of the target business].

The purchaser justified its use of a different accounting approach on the basis that the seller’s pre-closing calculations had been inconsistent with GAAP. When the seller objected, the purchaser initiated the dispute resolution process under the working capital adjustment provisions of the agreement. Under that process, issues relating to “items or amounts” in the calculation were to be referred “to a mutually agreed national accounting firm”, which would act as an expert. This was stated to be the “sole and exclusive method for resolving any Disputed Items”.

The issue on this motion was the correctness of the purchaser’s choice of this process. The seller insisted that, in the context of the agreement, its dispute with the purchaser was essentially a dispute over whether it had breached a representation (i.e. the representation in the PSA that its financial statements from 2010-2013 were GAAP-compliant). As such, in the seller’s view, the dispute should be resolved under the indemnity provisions of the agreement, which were stated to be:

…the sole and exclusive remedy … with respect to all claims of any nature whatsoever relating to the Transactions, including any breach of any representation….

Significantly, the preceding words were followed by a proviso that “nothing in this sentence shall operate to interfere with [the price adjustment provision]”. A second argument advanced by the seller was that it is common commercial practice to limit an accountant’s “expert” role in a price adjustment dispute to the resolution of calculation questions – an understanding that, in the seller’s view, was buttressed by the reference in the agreement to the accountant’s responsibility for resolving disputes over “items and amounts”.

One reason that the parties could not come to a consensus or settlement on this point was probably the fact that the agreement subjected indemnity-based recovery to a cap of $7.4m and a $4.9m deductible, while the only limit applying to purchase price adjustments was a $12.4m cap. The decision between the price adjustment and indemnity mechanisms therefore had important consequences for the amount that it would be possible to recover in the dispute.

While acknowledging that several earlier U.S. decisions had found that disputes over accounting principles were governed by the indemnity provisions of the agreements in question, the Court saw this case differently. Here, the agreement specifically required a deviation from past accounting practices to the extent that they were not GAAP-compliant. Thus it must have been contemplated that disputes over the proper extent of any such deviation would be resolved under the dispute resolution process in the price-adjustment provision. Furthermore, the “proviso” evidenced the parties’ intention to permit the use of the price adjustment dispute process in at least some situations that would otherwise have been appropriate for the judicial dispute-resolution process. Moreover, the choice of an accounting standard could be described as an “item” and was accordingly not excluded by the reference to “item or amount” in the price adjustment provision. Finally, while the Court agreed that it was “commercially sensible and logical” to limit the role of accountants to calculation issues, the parties in this case had not done so – indeed, their mutual insistence on a “national accounting firm” suggested that the possibility that the accountant’s function might extend beyond a mere “bean counting exercise” was within their contemplation.

The result was a specific performance order requiring the parties to proceed to a price adjustment dispute process as per the terms of their agreement.

Best Practices

Consider the following best practices when negotiating working capital adjustment provisions in M&A transactions:

  • Define all accounting terms that are used in the definition of working capital. Take care to ensure they are properly applicable to the business being bought or sold and make reference to specific line items on applicable financial statements.
  • Include a reference balance sheet. It should outline the calculation of the target and specifically identify what is to be included and excluded, including zero balances for line items to be included but which may not be applicable in calculating the target. Ensure the reference balance sheet is used to calculate both the target and the final working capital number. Ensure the same accounting standard applies to both.
  • Consider whether or not the statement should be audited.
  • Consider whether GAAP or consistency with prior statements should trump. Ensure that the calculation of the target and of the final working capital are consistent. Bear in mind that being GAAP-compliant may not be specific enough in the context of the treatment of certain items.
  • Be mindful of the interplay between the working capital adjustment and other clauses in your agreement. Ensure (for example) that there is no double counting and consider whether the inclusion of adjustments and representations and warranties on the financial assets or liabilities could cause unintended claims or consequences. If specific issues arise in diligence, a specific indemnity (and exclusion from working capital) may be a better solution than including the matter as a working capital adjustment.
  • Expert vs. arbitrator. Consider if the third party deciding matters in a dispute should be an expert or arbitrator and any limits on what they are entitled to determine or whether to impose a collar on the amount in dispute.
  • Draft the working capital dispute provision so as to limit the matters in dispute. Also consider whether the expert should have the authority to determine procedural matters with respect to the dispute.