Working Capital in an Equity Purchase Agreement

When buying or selling a business - especially in an equity transaction - it is essential to understand the concept of working capital. This term often appears in equity purchase agreements, such as stock purchase agreements and membership interest purchase agreements, and plays a vital role in ensuring the smooth transition of the business from the seller to the buyer.

What is Working Capital?

Working capital is the difference between a company’s current assets and current liabilities. Current assets include cash, accounts receivable, and inventory, while current liabilities include accounts payable and other short-term debts. In simple terms, working capital reflects the company’s day-to-day financial health and its ability to pay off its short-term obligations.

Why is Working Capital Important in an Equity Purchase Agreement?

Ensuring Business Continuity

When you purchase a business as a buyer, you want it to continue operating as smoothly as before closing. A sufficient amount of working capital ensures that the business has enough funds to cover daily operations, such as paying employees and vendors in the ordinary course of the business.

Determining the Purchase Price

The working capital at the time of the sale often affects the final purchase price. Depending on the agreement, a buyer may pay more if the working capital is higher than a predetermined amount, and less if there is a deficit.

Minimizing Risks

Both buyers and sellers want to minimize risks in a business sale. By defining the working capital requirements in the equity purchase agreement, both parties can set clear expectations and reduce uncertainties regarding the business’s cash portion.

How is Working Capital Managed in an Equity Purchase Agreements?

Setting a Target Working Capital

The buyer and seller often work towards a specific agreement on a target working capital that the business should have at closing. If the actual working capital is above or below this target, adjustments to the purchase price may occur.

Defining the Calculation Method

The purchase agreement must clearly define how working capital will be calculated. Well-crafted definitions and formulas prevent disputes and ensure that both parties are on the same page as this critical figure is tracked post-closing.

Post-Closing Adjustments

The equity purchase agreement may include provisions for adjustments after closing, based on the final calculation of working capital. This allows for corrections if the actual working capital differs from the estimated working capital amount typically provided by the seller at closing.

Takeaway:

Working capital is more than just a financial term; it is a critical component of buying or selling a business. Understanding and properly managing working capital in an equity purchase agreement ensures that both parties know what to expect, reduces risks, and contributes to a successful transition of the business.

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