Normalised working capital: the twelve-month calculation and the clause to draft

Of all the price adjustment mechanisms, working capital generates the most post-completion disputes. The reason is simple: it is the only one whose definition has to be written, and it is the one most often written in a hurry.

The principle itself is not controversial. The price assumes the business is delivered with the working capital its normal operations require. Delivered with less, the buyer must fund the shortfall from its own cash and deducts it from the price. Delivered with more, the seller must be paid for it.

One essential difference from EBITDA adjustments: a working capital gap is deducted from the price one for one, with no multiple. One hundred thousand dinars of gap is worth one hundred thousand of price, not six hundred. The discussion should stay proportionate: it is about real, unmultiplied amounts.

The calculation, month by month

Take the distribution business from our earlier examples, in thousands of Tunisian dinars. Here is its working capital at the last day of each of the twelve months of the year.

The gross twelve-month average is 2,066. The reference date is 31 December, when working capital stands at 1,910. The gap is therefore 156 against the seller, and that amount will be deducted from the price.

Why is December low? Because the company, like almost every company, accelerates collections at year end. Good management becomes a straight loss here, simply because the reference date falls on the low point of the year.

Cleaning the base changes the answer

The gross average is not the norm. Suppose that in May and June the company received an exceptional seasonal customer prepayment of 300, which mechanically reduced working capital in those two months and will not recur. Strip it out and May becomes 2,680, June 2,490, and the average becomes 2,116.

The gap against delivered working capital is then not 156 but 206. Fifty thousand dinars of price turn on a single methodological decision, taken before signing or suffered afterwards.

The four decisions

• The period. A twelve-month rolling average is market practice. Where the business is seasonal, extend it to twenty-four or thirty-six months so that one atypical cycle does not become the benchmark.
• Cleaning the base. Exceptional receivable, supplier dispute, non-moving stock, non-recurring prepayment, factoring introduced mid-year: anything that distorts a month must come out of the calculation.
• The perimeter. State in writing what belongs to working capital and what belongs to net debt. A tax receivable counted in net debt cannot also sit in working capital, or the seller is penalised twice for the same item. This is the most frequent and the most expensive mistake.
• The formula. Annex the detailed computation to the agreement, line item by line item, with a worked example applied to a past date. One worked example is worth ten paragraphs of definition.

The rule that prevents most disputes

It fits in one sentence, and it is the single most useful line in the agreement: any exclusion applied to the average must be applied identically to the working capital measured at the reference date.

Without that symmetry, each side strips from the average what suits it and leaves in the measurement what serves it. Disagreement is then mathematically guaranteed, and it will be settled by an expert months after completion, when the seller has no leverage left.

The adjustment deadband

A common practice is to provide a deadband: no adjustment is due where the gap stays below an agreed threshold, for instance 2% of the price or a fixed amount. It avoids mobilising advisers over a gap of a few tens of thousands of dinars, and it reduces the temptation, on both sides, to optimise the final days before the reference date. Where a deadband exists, the agreement must say whether the adjustment then applies to the whole gap or only to the excess above the threshold: both drafts exist and they do not produce the same figure.

A sample clause

A reference drafting, to be adapted to each deal with your legal counsel.

"Normalised Working Capital means the arithmetic average of the Working Capital amounts as at the last day of each of the twelve (12) months preceding the month in which the Reference Date falls, computed in accordance with the Formula set out in Schedule A and derived from the Monthly Accounts prepared in accordance with the Reference Accounting Principles. The items listed in Schedule B are excluded from the computation, including non-recurring customer prepayments, tax receivables and payables taken into account in Net Debt, and stock with no movement for more than twelve (12) months. Any exclusion shall apply identically to the computation of the average and to the Working Capital measured at the Reference Date. No adjustment shall be due where the difference between the Working Capital measured at the Reference Date and Normalised Working Capital is lower in absolute value than [amount]."

What we do

We rebuild working capital month by month over twenty-four months, identify and document the items to exclude, check that nothing is double counted against net debt, then draft the formula and its worked schedule so that legal counsel can carry it into the agreement. On a sale, this is the work with the most immediate return: it is measured in dinars of price preserved.

See also our transaction advisory services, purchase price adjustments and adjusted EBITDA.

General information prepared by the Transaction Advisory Services team at MGI BFC. Figures and the sample clause are illustrative and do not constitute legal advice.

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