Parties to a business transaction, whether structured as a purchase of equity or assets, typically agree on a method to adjust the purchase price based on the net working capital of the acquired business as of closing.

Generally, net working capital is determined by subtracting the business’ current liabilities from its current assets, excluding cash. Transactions are commonly structured on a “cash free” basis with the seller retaining the cash as of closing and therefore cash would be excluded from the net working capital calculation.

The theory behind net working capital adjustments is that the buyer expects to receive a level of net working capital sufficient for the continued operation of the business. If the net working capital is lower than what is needed to operate the business, then the buyer would, absent a net working capital adjustment, be required to fund such shortfall to continue operations and effectively increase the purchase price by such amount. Net working capital adjustments also avoid either the buyer or seller receiving a windfall based on the timing of collection of accounts receivable, payment of accounts payable and the sale of inventory.

Net working capital adjustments involve the buyer and seller establishing a target net working capital. The actual net working capital as of closing is then measured against the target net working capital. If the actual net working capital exceeds the target net working capital, then the buyer pays the excess to the seller. If the target net working capital exceeds the actual net working capital, then the seller remits the excess to the buyer. In some transactions, the parties will adjust the purchase price based on an estimated net working capital as of closing that will be “trued-up” following closing.

Due to the time it takes to prepare the financial statement information necessary to calculate the net working capital as of closing, the parties will agree to a post-closing period to calculate and agree on the final net working capital as of closing. The process routinely involves the buyer providing its calculation of the net working capital as of closing to the seller and the seller having a certain period to object to such buyer calculation. The parties’ unresolved differences are often referred to an independent accountant who makes a final, binding determination.

It is important for lawyers to assist their clients in understanding the net working capital adjustment process. Lawyers for the buyer should confirm that the specific assets that are used to calculate the net working capital do not include assets that are excluded from the transaction. Lawyers for the seller will want to confirm that the liabilities used to calculate the net working capital are liabilities that buyer will discharge after closing and not debt for which the seller is typically obligated to satisfy at closing. Lawyers are also involved in crafting language in the transaction agreement that incorporates a consistent set of agreed upon accounting standards used to calculate the target net working capital, any estimated net working capital, and the final net working capital so that the parties are comparing “apples to apples.”