Working capital and stock adjustments at settlement

The headline price in a business sale is rarely the amount that changes hands on the day. Stock, debtors, prepaid expenses, employee leave and other items are added or subtracted at settlement, and these adjustments can move the final figure by tens of thousands of dollars or more. Many disputes in business sales are about adjustments rather than price, and most of them could have been avoided by agreeing the method early.

Why adjustments exist

A business is a moving thing. Between the day a price is agreed and the day the business changes hands, stock is bought and sold, customers pay, bills arrive and staff accrue leave. Adjustments make sure that the buyer receives what they paid for and that the seller is paid for what they hand over, as it stands on settlement day.

How adjustments work depends heavily on whether the sale is of business assets or of shares. See asset sale vs share sale for the broader differences.

Stock in an asset sale

In many small business asset sales, the price is expressed as a figure for goodwill and plant plus stock at valuation. The contract should answer these questions clearly.

How stock is counted

A stocktake is usually done at or just before settlement, often jointly by both parties or by an independent stocktaker. Agree who does it, when, and how disputes over the count are resolved.

How stock is valued

Stock is commonly valued at cost, or at the lower of cost and net realisable value. The contract should state the method and define what counts:

• Saleable stock at the agreed value;
• Slow-moving, damaged or obsolete stock excluded or written down;
• Stock on order or in transit dealt with separately.

Minimum and maximum levels

Many contracts set a range, for example that stock at settlement will be between $80,000 and $120,000. This protects the buyer from paying for an overstocked store and protects the seller from a buyer who wants the business stripped bare. As an illustration, if the agreed range is $80,000 to $120,000 and the count comes to $135,000, the buyer may be able to refuse the excess or pay only up to the maximum, depending on the wording.

Working capital more broadly

In larger deals, and in most share sales, buyers look beyond stock to the business's whole working capital: broadly, current assets such as debtors, stock and prepayments, less current liabilities such as creditors, accruals and employee provisions.

The reason is simple. A business needs a certain level of working capital to trade normally. If a seller collects every debtor, runs stock down and stretches creditors before settlement, the buyer inherits a business that needs a cash injection on day one.

The working capital target

A common approach is to agree a target or peg: the normal level of working capital the business needs, often based on an average over the previous 12 months to smooth out seasonality. At settlement, the actual working capital is compared to the target:

• if it is above the target, the buyer pays the difference to the seller;
• if it is below the target, the price is reduced.

As an illustration, if the agreed target is $250,000 and working capital at settlement is $230,000, the price would fall by $20,000. If it were $270,000, the price would rise by $20,000.

Defining the items

The adjustment is only as clear as the definitions. The contract should specify:

• exactly which balance sheet items are included and excluded;
• the accounting policies used to measure them, consistent with how the target was set;
• how and when the settlement balance sheet is prepared, and by whom;
• how long the other party has to review it, and how disagreements are resolved, often by referral to an independent accountant.

Other common adjustments

Whatever the structure, contracts often adjust for:

• Prepaid expenses, such as rent, insurance or subscriptions paid in advance by the seller for a period after settlement;
• Outgoings, such as rates and utilities, apportioned on a daily basis;
• Employee entitlements, where the buyer takes on accrued leave that staff earned while working for the seller. See employee entitlements when a business changes hands;
• Customer deposits and prepayments, where the seller has been paid for work the buyer will have to deliver;
• Lease bonds or security deposits, depending on how the lease is dealt with.

Debtors and creditors in an asset sale

In a typical small business asset sale, debtors and creditors stay with the seller. The seller collects what they are owed and pays what they owe. That is simpler, but it needs managing: customers may pay the wrong party after settlement, and suppliers may expect continuity. Agree how misdirected payments are handled and passed on.

GST and adjustments

If the sale is a GST-free supply of a going concern, the GST treatment of adjustments should be consistent with that. If the sale turns out to be taxable, adjustments can be affected too. Make sure the contract deals with GST on adjustment amounts.

Practical tips

1. Agree the method in the heads of agreement. Do not leave adjustments to be worked out in the contract. See our article on letters of offer and heads of agreement.
2. Use consistent accounting policies. The settlement figures should be prepared the same way as the figures used to set the price or target.
3. Keep trading normally. Sellers should run the business as usual before settlement, without running down stock or delaying payments.
4. Prepare early. Have a reliable stock system and up-to-date balance sheet so there are no surprises at the count.
5. Have a dispute process. A clear, quick mechanism for resolving disagreements, such as an independent expert, avoids expensive arguments.

Adjustments are where a fair price can quietly become an unfair one. Agree how they will be calculated before you agree the deal, and write it down.

How we can help

Kainos sets working capital targets, prepares and reviews completion statements, and represents clients at the stocktake and in resolving adjustment questions, working alongside their lawyer on the contract wording. We act for both buyers and sellers. To talk about a transaction, contact us or read about our business sales and purchases service.

This article is general information only and does not take into account your circumstances. Speak to a qualified adviser before acting on it.