When you buy a house, you expect that the purchase price you are paying for the house includes certain key facets: a roof that does not have holes, a working HVAC system, running water. Typically, real estate purchases are subject to inspections to ensure that this is true because if not, the purchase price is adjusted based on the repairs that need to be done. So, in this example, a house with a price of $1,000,000 will likely have to reduce its price by say $100,000 if the roof needs a complete repair. This is because the alternative is that the buyer will have to pay $1,000,000 for the house and then spend another $100,000 for a total of $1,100,000 for a house he thought and budgeted for was worth less.
When you purchase a business that is running in the ordinary course (and not a distressed company), it similarly has a value and the purchase price is (ideally) based on this value. Much like the house example, the purchase price that a buyer expects to pay for this business should have certain “things” within it as well to help it run in the ordinary course, whether or not the business is being sold. These things are usually called “current assets” such as: cash in the bank, money coming in from the sale of inventory or from collecting accounts receivable or work-in-progress (depending on the type of business), and the liquidity extracted from these assets are used in the short-term to pay for the short-term liabilities that leave the bank account every month: payroll, rent, payables etc.
The amount of short-term assets the business needs to help cover these liabilities every month is, in practical business terms, called: “working capital.” (Note that I wrote “in practical business terms”, I did not say “accounting terms” or “legal terms.”)
So, when a buyer wants to purchase a business, it is expected that there is a sufficient level of working capital left in the business, otherwise he will have to pay more for the business to fix the working capital and pay for its short-term liabilities post-closing much like the purchaser of real estate having to pay more for a roof if it is in disrepair. What’s more, the buyer’s entire financing structure is based on sufficient working capital, so in many cases, without sufficient working capital, it could cause the buyer to default on its covenants to its lenders.
The issue with working capital is that sellers attempt to strip as much working capital from the company prior to closing — unlike in a roof scenario, it’s unlikely a seller will destroy the roof or take it with them when they leave. This makes sense so the sellers will get as much value out of the company as possible prior to selling it. This means if there is cash in the account, they pay it to themselves, if there are old bills that need to be collected, they call up their customers and offer discounts to collect before closing and so forth. But if the company is left without or with insufficient working capital, then (much like the house with holes in the roof), the buyer now, on top of the purchase price, has to inject more money into the business to cover its liabilities like payroll and rent.
As a result, the buyer will have overpaid for the business. Many sellers push back on leaving working capital in the business and suggest that it is “their money” that is helping fund the business when they no longer own it. However, their business would not have been worth the value it sold for without maintaining sufficient working capital going forward.
Since working capital is an intangible number that is usually determined after closing (versus a roof in disrepair that can be seen prior to closing), there is typically a process to help determine whether or not a seller left enough working capital in the business and how to adjust accordingly. This process is supposed to be properly drafted in legal documents. One standard process usually follows these steps:
- After due diligence, working capital is estimated by the buyer and a target number is set based on its components (i.e., the buyer expects there to be $300,000 of working capital made up of at least $100,000 of accounts receivable etc.). Since working capital could change every day, sometimes a target range of working capital is provided;
- Closing occurs based on this target working capital and the seller provides an estimated closing balance sheet right before closing showing the target is met;
- There is then a post-closing period to ensure that the estimated working capital was in fact met and not incorrect or based on manipulated accounting rules. If the buyer finds there is less than the target (say $200,000 and not the $300,000 target), the purchase price is reduced and the seller owes the money back to the buyer; if there was excess money than the target, the buyer will owe more money to the seller in addition to the purchase price.
Seems simple enough.
Unfortunately, where disputes happen is, ironically, when professionals get involved. For example, in accounting, working capital is defined simply as current assets minus current liabilities. Current assets are accounts receivables, inventory, cash and equivalents and prepaids etc. But no two businesses are the same. Many lawyers simply copy and paste standard definitions in precedents or from the accountants involved without understanding the underlying businesses. This can lead to disastrous and absurd results for their clients.
For example, I witnessed one transaction where the seller was supposed to leave $500,000 in working capital in an inventory distribution business. The estimate working capital was $1,000,000, most of which was contained in inventory, and the seller expected the excess $500,000 stated on paper was to be paid back post-closing. The trouble is that the inventory was not able to be sold within 30 days from closing and in some cases, not able to be sold at all.
This created a problem with the business where it did not have enough cash coming in post-closing to pay for payroll and other liabilities. This is because in this particular business, the way it runs in the ordinary course is that a certain type of its inventory must be kept on hand and sold within 30 days to pay for its liabilities, but this type of inventory did not remain in the business on closing.
The legal documents that had been drafted did not differentiate between inventory type or define “inventory” as those that could be sold within 30 days. As a result, the buyer (stuck with a business he paid millions for) was forced to inject additional money into the business to pay for its short-term liabilities.
To make matters worse, the buyer owed the seller an additional $500,000 for working capital excess based on the legal definitions in the purchase agreement and the supposed “excess working capital” on paper. The seller took the buyer to court, won, and the business shut down given the buyer was now in breach of its banking covenants.
Working capital disputes happen all the time, so transaction lawyers should not blindly rely on precedent working capital clauses or those provided to them from accountants. Instead, it is crucial that transaction lawyers spend some time with their client to understand their businesses and ensure there are proper mechanisms in place to arbitrate disputes that arise in this area. If lawyers are entrusted to draft agreements to reflect business realities, they require greater training (even from their own clients) to assist in this crucial and rarely understood part of business transactions.
This article was originally published by Law360 Canada, part of LexisNexis Canada Inc.
