When selling a business, one of the most crucial financial aspects to consider is the working capital target in the share sale agreement. Working capital adjustments can have a direct impact on the final proceeds a seller receives from the transaction. However, many sellers overlook this factor, focusing primarily on the headline purchase price without fully understanding how working capital adjustments influence their net proceeds.
Let’s break down what a working capital target is, why it matters, and how sellers can strategically plan for adjustments to avoid unpleasant surprises at closing.
What Is a Working Capital Target?
Working capital is the difference between a company’s current assets (such as accounts receivable and inventory excluding cash or cash equivalents) and its current liabilities (such as accounts payable and accrued expenses). It is a key financial metric that ensures the business can operate smoothly post-sale.
In a share sale agreement, the working capital target is a predetermined level of working capital that the seller is expected to deliver at closing, meaning it is the amount of cash a seller must leave in the bank account. This ensures the buyer receives a business with sufficient short-term liquidity to continue operations.
The target is typically based on a historical average of the company’s working capital over a period, such as the past 12 months, to reflect normal operating conditions.
Why Is the Working Capital Target Important?
If the working capital delivered at closing is higher or lower than the agreed target, a working capital adjustment occurs, which can increase or decrease the seller’s final proceeds. This adjustment is critical because it:
Protects the Buyer from Unexpected Shortfalls
Buyers want to ensure they are acquiring a business that can sustain itself financially from day one. A working capital target prevents the seller from reducing working capital (e.g. delaying payables or aggressively collecting receivables) before closing to maximise cash proceeds.
Prevents Seller Manipulation of Short-Term Finances
Without a working capital target, sellers might be incentivised to artificially reduce liabilities or inflate assets before the transaction to make the business appear more valuable. The target ensures fair play by keeping working capital at a normal level.
Affects the Final Sale Price
The final purchase price is adjusted based on the difference between the actual working capital at closing and the agreed target. If the delivered working capital is lower than the target, the seller must compensate the buyer for the shortfall. Conversely, if working capital exceeds the target, the seller may receive an additional payment.
How Sellers Can Prepare for a Working Capital Adjustment
To avoid unexpected reductions in net proceeds, sellers should:
Review Historical Working Capital Trends: Analysing working capital levels over the past 12 to 24 months can help anticipate what the target might be.
Negotiate the Target Fairly: Ensure that the working capital target reflects a realistic operating level and does not place an undue burden on the seller.
Monitor Working Capital Leading Up to Closing: Avoid aggressive financial manoeuvres that could reduce working capital and trigger a negative adjustment.
Factor Adjustments into Net Proceeds Calculations: Before committing to a deal, sellers should estimate the potential working capital adjustment and how it may impact their final cash proceeds.
Final Thoughts
The working capital target in a share sale agreement is a critical component that sellers must understand and plan for. It directly impacts the net proceeds they receive from the sale, and failure to anticipate adjustments can lead to financial shortfalls. By proactively managing working capital and negotiating a reasonable target, sellers can maximise their final payout and ensure a smooth transaction.
If you would like to discuss how to structure your share sale agreement to optimise your net proceeds, speak to a VBA transaction specialist to get expert guidance tailored to your business.
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