INSIGHT: Steps to Prevent Costly Post-Sale Working Capital Shortfall Disputes

A host of issues can stall a major private equity deal, but one of the most frequent post-sale disputes centers on determining the amount of working capital shortfall for the acquired company.

The goal is to accurately capture the shortfall, if any, for the period of time between the execution of the purchase agreement and the closing of the deal. The amount agreed upon must be sufficient to operate the business on a day-to-day basis, but not so much to create a windfall for the buyer.

Typically, a dispute over working capital will arise several months after closing, once the buyer has had the opportunity to present its working capital calculation to the seller. At that point, the leverage that the parties may have had while negotiating the deal is gone and the parties are left to apply whatever formula for calculating working capital that is set forth in the purchase agreement.

Early planning makes a difference, so one of the top pre-sale planning goals should be to get consensus from buyer and seller on an appropriate formula for calculating working capital for the specific type of business being sold.

Consensus should also be sought on the dispute resolution procedures that the parties wish to follow in the event a dispute arises.

Separate Dispute Resolution Mechanism

For example, will a working capital dispute be subject to the same arbitration clause that governs other disputes that arise between the parties? If so, a seller may find itself tied up in complex, time-consuming litigation where a buyer is pursuing fraud or other rep-and-warranty style counterclaims at the same time a seller is seeking the return of a working capital escrow.

The working capital dispute—which would otherwise be a streamlined matter that could be resolved in a matter of months—may now get held up for years. Therefore, considering a separate dispute resolution procedure for working capital and earn-out disputes is a key component of negotiating a purchase agreement.

Without careful planning, the difference in a buyer’s and seller’s valuation of working capital at closing may easily stretch into the hundreds of thousands of dollars, if not more. Leaving the negotiation of the working capital provision until the end of the negotiation typically means less attention will be paid to critical components, including the appropriate formula for calculating working capital, and it means that post-closing litigation is more likely.

In one of the more infamous illustrations of what can go wrong, the dollar differential in each side’s estimation of working capital in a dispute back in 2015 actually exceeded $2 billion. Costly and complicated litigation ensued, spanning the better part of two years. This dispute between Westinghouse Electric and Chicago Bridge & Iron, if nothing more, is a clarion call for all to heed the need for qualified counsel’s involvement from the outset.

Critical Considerations

You need to take many factors into account when coming up with your definition of working capital. For instance, will deferred revenue be part of the working capital calculation or just post-closing expenses associated with that deferred revenue? Are there other factors unique to the acquired company’s accounts receivable that need to be taken into account so that neither buyer nor seller is receiving a windfall?

Outside of the U.S., cross-border transactions are a different animal, in that variations between U.S.-applied generally accepted accounting principles (GAAP) and the GAAP that predominate in foreign jurisdictions need to be taken into account. More to the point, GAAP may differ significantly in ways that unfortunately are not readily apparent to U.S. buyers or sellers. How those differences are addressed in the definition of working capital may prove meaningful to any post-closing purchase price adjustment.

In the event a dispute arises, a key consideration is having a streamlined dispute resolution procedure that places the dispute outside of any other proceeding that may arise under the purchase agreement and squarely in the hands of a capable neutral accountant.

It is also important to consider placing limitations on the ceiling and floor of any working capital amount to protect the parties against wide swings that may turn an advantageous deal into an albatross.

The parties should also ensure that there is a “time is of the essence” clause in the agreement so that a party’s failure to deliver a working capital statement forecloses that party from recovering, or challenging, the working capital shortfall.

Earn-Outs

An earn-out is a common purchase agreement provision compensating sellers for near-future potential not reflected in the closing purchase price. In other words, if everyone knows a windfall is coming down the road, you can factor that into the pricing from the get-go, so your numbers are fair.

Also, if the seller is making promises that the buyer does not think are reasonably likely to pan out, then an earn-out works as an insurance policy against the risk. The seller only gets paid if that future business materializes.

Earn-out provisions are typically structured to provide that, if certain targets are met after closing, then the seller is entitled to additional contingent payments. Those payments are typically a percentage of revenue.

However, another pre-sale planning item is to determine what revenue is counted for purposes of the earn-out. Is revenue from new customers obtained after closing part of the earn-out calculation or just existing customers at the time of closing, for example?

Recommendations

The devil is in the details. For the calculation of net working capital and any earn-out formula, think about whether there are unique attributes to the business and how it collects its revenue that warrants deviation from the typical definitions.

Are there revenue or expenses that need to be excluded from either calculation? Does the earn-out have a floor—or a ceiling—so that it does not strangle the buyer’s nascent business? Are escrows needed to ensure that the seller is still around to live up to its bargain months after closing when the working capital shortfall comes due?

And when it comes to the escrow, the parties should consider whether it is the exclusive remedy or if a party can seek to recover in excess of the escrow amount. A final consideration is whether, and when, the escrow expires.

Finally, careful attention must be paid to the dispute resolution procedure and the speed with which it operates. A tightly worded provision will be a savior for a frustrated buyer or seller who simply wants to resolve the dispute, collect what is owed, and go back to focusing on the next deal, not the last one.

Simply put, you don’t want to be caught shirking when it comes to your attention to detail. By focusing attention on working capital shortfall and earn-out provisions during the negotiations, when you have the most leverage, you can lay the groundwork to avoid a dispute, or expedite a resolution if a dispute arises.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Ryan Roman is a litigation partner in Akerman’s Miami office. He takes a results-oriented approach to resolving disputes commonly faced by private equity firms and their portfolio companies.

Donnie M. King is an associate in Akerman’s Miami office. He handles high stakes securities and private equity litigation, proxy contests, securities fraud, business torts and civil theft lawsuits.