Working Capital Adjustments in Divestiture Transactions

In the world of mergers and acquisitions (M&A), divestitures play a critical role in reshaping a company’s portfolio. A divestiture refers to the process where a company sells, liquidates, or otherwise disposes of one of its business units or assets. While the strategic reasons for divestitures can range from improving focus on core operations to raising capital, the complexity of the transaction often requires careful financial management. One of the most important aspects of this financial management involves working capital adjustments.

What is Working Capital?

Before diving into the nuances of working capital adjustments, it’s essential to understand what working capital is. Working capital represents the difference between a company’s current assets (like cash, receivables, and inventory) and its current liabilities (such as accounts payable). This metric is a key indicator of a company’s operational efficiency and short-term financial health.

In a divestiture, the buyer and the seller must agree on an appropriate working capital target to ensure that the business being sold is financially stable and able to operate without immediate liquidity concerns after the transaction. If there is a significant difference between the agreed target and the actual working capital at the time of the transaction, adjustments will need to be made.

Importance of Working Capital Adjustments

Working capital adjustments are crucial in divestiture transactions for several reasons:

1. Preserving Operational Continuity: The seller’s business unit might have accumulated inventory, receivables, or other current assets that will be transferred to the buyer. Similarly, the seller may also have outstanding liabilities that need to be settled or transferred. A working capital adjustment ensures that the buyer is not overburdened with the seller’s existing financial obligations, while also ensuring that the seller is not leaving behind critical resources or assets that are essential for the business’s ongoing operations.

2. Mitigating Risk for Both Parties: The agreed-upon working capital target serves as a buffer to mitigate risks related to fluctuations in the value of current assets and liabilities. By adjusting the purchase price based on actual working capital, both parties ensure that the buyer pays a fair price for the business, and the seller does not face a loss due to underestimating the working capital needs.

3. Negotiation Leverage: Working capital adjustments can be a useful tool during negotiations. If either party believes the target working capital figure is too high or too low, they can use it as a point of leverage to adjust other terms of the deal, including the final price or other contingencies. In cases where the seller believes the business’s working capital is undervalued, they may adjust the purchase price to reflect that.

The Mechanism of Working Capital Adjustments

The process of working capital adjustments typically involves the following steps:

1. Setting a Target Working Capital: The buyer and the seller agree on a target working capital figure. This figure is typically based on historical data, such as the average working capital over the last few months or years. However, adjustments may also consider seasonal fluctuations or industry-specific factors that affect working capital needs.

2. Transaction Completion: Upon closing the transaction, the working capital of the business is measured. This often takes place on the closing date, although in some cases, it can occur shortly after the closing. The goal is to capture the working capital as it stood at the time of the transaction, factoring in the business’s operational cycle and any changes that may have occurred in the period leading up to the sale.

3. Adjustment Calculation: After the actual working capital has been measured, the buyer and seller will compare this with the agreed-upon target. If the actual working capital exceeds the target, the buyer may be required to make an additional payment, while if it falls short, the seller may owe the buyer an amount to adjust the discrepancy.

4. Dispute Resolution: In some cases, disagreements may arise over the calculation of working capital or the adjustments needed. This can be resolved by referring to the terms of the purchase agreement, which typically outlines the methodology for calculating working capital. If necessary, external experts, such as auditors or consultants, may be brought in to help resolve these disputes.

The Role of Divestment Consulting

One of the key areas where expert advice is invaluable in a divestiture transaction is in the area of working capital adjustments. Divestment consulting firms specialize in helping businesses navigate the complex financial and operational aspects of selling a business unit or asset. These consultants have experience in evaluating the working capital needs of a business, setting appropriate targets, and helping both parties reach an agreement that accurately reflects the value of the business being sold.

Additionally, divestment consulting firms can assist in the negotiation process, ensuring that both the buyer and seller understand the implications of working capital adjustments and that the final terms of the transaction reflect a fair deal for all parties. These experts can also provide guidance on post-transaction issues, such as ensuring a smooth transition of assets and liabilities.

Key Considerations for Working Capital Adjustments

1. Seasonality: For businesses that experience significant seasonal fluctuations in inventory or receivables, it’s important to account for these variations when setting a working capital target. This can be particularly challenging for companies that operate in industries such as retail or agriculture, where cash flow and working capital requirements can shift dramatically based on the time of year.

2. Operational Changes: If the seller has recently made significant operational changes, such as restructuring or scaling operations, these changes may impact working capital. Both parties need to consider these factors when negotiating the target working capital.

3. Audit Rights: Both the buyer and the seller should have the right to audit the working capital calculation. Ensuring transparency in the process is crucial for minimizing disputes and ensuring that the adjustment is based on accurate data.

4. Post-Closing Adjustments: Sometimes, it’s not possible to finalize the working capital adjustment at closing. In such cases, a post-closing adjustment mechanism can be included, where both parties agree to an independent audit or review process that will determine the final working capital adjustment.

Conclusion

Working capital adjustments are a fundamental aspect of divestiture transactions, ensuring that both the buyer and seller are treated fairly and that the business operates smoothly after the transaction is completed. By establishing a clear target working capital and negotiating adjustments as necessary, both parties can mitigate financial risks and ensure that the sale reflects the true value of the business. Engaging the expertise of divestment consulting professionals can be instrumental in navigating this complex process, ensuring that working capital adjustments are accurately calculated, fairly negotiated, and properly executed.

References:

https://www.atoallinks.com/2025/cultural-due-diligence-in-cross-border-divestitures/