You’ve found a target company, made an offer, completed weeks of due diligence, spent countless hours planning for integration and just before you’re ready to sign on the dotted line, the notion of working capital hits the negotiation table. The success of the deal now hinges on ensuring working capital targets, and any potential adjustments, satisfy the interests of both the buyer and seller. It doesn’t matter how big the deal is, at some point, and perhaps initially with no apprehension, you’ll encounter a discussion about working capital during the M&A process.
As advisors we have routinely witnessed the problems that arise from failing to appropriately negotiate working capital targets early in the process. These problems can limit the ability of both parties to come to consensus in other areas of negotiation and can ultimately have profound impacts on the final sale price of the company.
Why all the Confusion?
The textbook definition of Working Capital is fairly simple: Current Assets minus Current Liabilities. Most often, in a private company context, cash and any redundant assets (assets that are not necessary to the business operations) are excluded from the working capital calculation. This also aligns with a typical transaction being completed on a cash free, debt free basis. Working capital is commonly referenced as an intrinsic measure of a company’s financial health and its ability to cover its short term debts. Evaluated on its own, working capital provides little true insight into the business but since it relates to the short-term cash requirements of the company, it can have very profound impacts during a transaction.
In the lead-up to the closing date, working capital accounts will fluctuate based on the normal course of business due to the timing of projects, receivables, and payables. Since successful M&A transactions are completed on the basis of an alignment of expectations – in deals where no working capital targets have been defined, fluctuations will only serve to create unnecessary tension between the buyer and seller as the closing date nears.
Working capital is also often initially calculated from year-end financial statements, when in reality, normal working capital requirements can be far different than what is reflected at a single point in time. If an account is excluded on the basis of determining the value (price) of the business, it should also be excluded from the working capital calculation. These might include warranties, dividends payable, stale inventories and any other accounts that are not being transferred upon closing. There are numerous factors that will affect the working capital of the company. Common items include:
- Timing of payables/receivables throughout the month
- The type of business
- Accounting policies
- Unusual events or practices
- The growth rate of the company
Working Capital and Valuation
Is working capital included in the valuation price? Yes and no. Since the estimation of value (price) is most often determined as a factor of the cash flows generated by a business, working capital targets set during a sale process should reflect the levels required to generate those flows. For businesses that are a going concern, the current assets and liabilities transferred at closing should reflect and be as close as possible to the amounts that were used to estimate the purchase/sale price. When the actual level of working capital at closing differs from the targets set, most often the purchase price will be adjusted up or down – commonly referred to as a ‘true-up’. In an ideal transaction – the level of working capital at closing should be close to the agreed upon targets so that the purchase price is not adjusted up or down.
‘Working’ the System
Still, a problem arises where working capital targets are set but the seller manipulates the accounts in the lead-up to closing. Since the business will often be sold on a cash free, debt free basis (seller retains the cash) – the seller might be incentivized to lengthen payable days and tighten up receivable days. Therefore, not only does a target working capital need to be defined, but it may also be imperative to negotiate appropriate working capital levels for each account prior to due diligence and closing. M&A transactions are an inherently iterative process but the methodology used to determine working capital targets should be defined as early as possible and adjusted through the due diligence process.
At the very least, the following items should be addressed in the EOI/LOI* stages of the transaction:
- Definition of and accounts to be included in working capital calculation
- Formula used to calculate it
- The mechanism upon which the purchase price will be adjusted up or down
Working capital negotiations in the context of M&A can have big impacts on the success of a deal. Business decisions are often, at least in part, determined by a risk/reward analysis. Working capital requirements should form part of this analysis where discussions are evaluated congruently with other major deal points.
There is no standard when it comes to working capital targets, they are specific to the business, industry and most importantly, to the expectations of the buyer and seller. The challenge is not only to determine the appropriate working capital needs of the company, but also to engage in negotiations to ensure working capital targets are agreeable by all parties. Be sure to deal with any working capital issues early and involve your advisors for guidance to ensure that you are capturing the maximum value of your business.
*EOI – Expression of Interest
*LOI – Letter in Intent
Gilbert, B. B. (n.d.). Working Capital Adjustments in M&A Transactions. G&R Review.
IN. (2014). Investopedia. Retrieved 11 01, 2016, from http://www.investopedia.com/terms/w/workingcapital.asp
Roblin, B. (2013). Putting the Pin in Net Working Capital:. Prepared for the 2013 Ian R. Campbell Research Initiative.