Establishing Accounting Policy Priority in Share Purchase Contracts
Establishing an explicit contractual accounting priority hierarchy in purchase contracts prevents retroactive working capital adjustments and protects deal value.
Working Capital Target
Meaning
Quantitative financial benchmarks representing the necessary short-term liquidity of a company at the point of sale prevent sellers from draining cash before closing. The working capital target establishes a baseline against which the actual assets and liabilities are measured on the closing date. This protects the buyer from receiving a business without the funds to operate.
Baseline Calculation
Historical financial performance is analyzed to determine the average requirements of the business over the preceding twelve months. Negotiating the working capital target is a critical part of the transaction because it directly influences whether the seller receives a price increase or a reduction at closing, and both parties must agree on which items of current assets and current liabilities are included in the final formula to avoid post-closing disputes.
Closing Adjustment
Final accounts prepared after the transfer of ownership are compared to the agreed benchmark. If the actual working capital is less than the working capital target, the seller must compensate the buyer for the shortfall. This adjustment is settled using the cash escrow.
Cash Flow
Operations can suffer if the business is handed over with insufficient liquidity. Setting a realistic working capital target ensures that the acquired company can continue to pay its suppliers without requiring an immediate equity injection.