Transaction Tuesdays - The NWC Adjustment, Part I

After months of negotiations have resulted in an agreement on purchase price, it’s easy to think that everything important has been decided in a deal.  But that’s not the case.  At Horizon, we have found that many key terms involved in an M&A transaction often come as a surprise to sellers.
 
As a deal gets into serious due diligence, lawyers begin to circulate drafts of definitive deal documents.  The documents are dense.  So it’s easy to miss that many critical issues are still in play.   Given that many of these terms can have a material – if seemingly subtle – impact on the overall attractiveness of a deal, we believe that at least a high-level understanding of key terms should be reached by both buyers and sellers before they engage in crucial transaction negotiations.  “Transaction Tuesdays” is our attempt to prepare our readers for some of the key issues that they will encounter when they pursue a transaction.

Our first series of Transaction Tuesdays posts will deal with one of the most common mechanisms used to adjust the “face value” price of a deal:  the net working capital adjustment.  Defined as current assets minus current liabilities, working capital is a measure of a company's efficiency as well as its short-term financial health.  Whether a company is managing working capital efficiently is usually a fairly innocuous issue tackled during due diligence for Internet and technology companies, since a buyer can manage working capital however it wishes post transaction.  However, the purchase price impact of a buyer’s “target working capital balance” at close vs. the company’s actual working capital at close is not necessarily as innocuous, particularly under certain circumstances.

Next Tuesday (10/19/2010), we will kick off the net working capital adjustment conversation with a fundamental analysis of buyer/seller interests in managing and adjusting working capital targets.  We will also introduce some of the common issues and pitfalls that buyers and sellers run into when negotiating a working capital adjustment.  One particular issue that we will cover in Part III of the series, the impact of deferred (unearned) revenue in working capital adjustments, was particularly important to each of buyer and seller in Neutron Interactive’s acquisition of EnticeLabs, a recent Horizon Partners transaction.  Please let us know if there are other components of working capital that you would like us to discuss through the series.

In the future, we will discuss other key terms in a transaction such as representations and warranties, escrow, and indemnification.  These terms might appear legal and mundane, but they actually have important business ramifications that every entrepreneur should understand.