Corporate Finance Advisors
After more than 25 years working on M&A transactions, first as a corporate tax and M&A lawyer and now as an M&A advisor, I have seen many transactions where the parties spend considerable time negotiating the headline purchase price, only to discover that another number can have a significant impact on the seller’s ultimate proceeds: Working capital.
It may sound like an accounting detail. It isn’t.
In most private-company M&A transactions, working capital is an important part of the economic bargain between Buyer and Seller. A poorly defined working capital mechanism can create an unexpected purchase-price adjustment, delay closing or result in a dispute after the transaction has closed.
For business owners contemplating a sale, understanding this concept before negotiating a letter of intent can be extremely important.
At its simplest, working capital generally represents a company’s current operating assets less its current operating liabilities.
Depending on the business and the terms of the transaction, that may include items such as:
Cash, indebtedness, income taxes and other specified items are commonly dealt with separately, although the precise definition is transaction specific.
The underlying principle is straightforward.
A Buyer purchasing an operating business generally expects to receive the business with a normal level of working capital necessary to continue operating it after closing.
The Seller, meanwhile, should receive the benefit of the value negotiated for the business without unnecessarily leaving excess working capital behind.
That is where the negotiation begins.
Most transactions involving a working capital adjustment establish a target, sometimes referred to as a “peg.”
Assume, for example, that a business is being sold for an enterprise value of $10 million, subject to a normalized working capital target of $1 million.
If the agreed closing working capital is $1.2 million, the Seller may be entitled to a $200,000 upward purchase-price adjustment.
If closing working capital is only $800,000, the purchase price may instead be reduced by $200,000.
Suddenly, a seemingly technical accounting provision has changed the Seller’s proceeds by hundreds of thousands of dollars.
On larger transactions, the difference can be considerably greater.
The arithmetic is usually the easy part.
The harder question is determining what level of working capital is actually normal for that particular business.
Buyers will generally want sufficient working capital to operate the acquired business without having to inject additional cash immediately following closing.
Sellers will want to ensure that the target does not require them to effectively transfer value to the buyer beyond what was contemplated when the purchase price was negotiated.
A common starting point is an historical average, often based on monthly working capital over an agreed trailing period.
But simply taking a 12-month average does not necessarily produce the right answer.
The analysis may need to consider:
A seasonal distributor, for example, may require substantially more inventory at certain times of the year than at others. A rapidly growing business may require more working capital today than its historical average suggests.
The appropriate target should reflect the economics of the business, not simply the output of a formula.
One mistake Sellers can make is focusing almost exclusively on valuation and the headline offer when assessing an acquisition proposal.
Suppose a Buyer offers $15 million for a company That sounds straightforward, right?
But if the offer is actually $15 million on a cash-free, debt-free basis subject to a normalized working capital adjustment, the Seller cannot fully evaluate the economics of the offer without understanding the proposed working capital methodology.
A Buyer proposing a $1.5 million target and a Buyer proposing a $2 million target may technically both be offering “$15 million,” but the economics to the Seller may be very different.
That is why I generally believe the basic working capital methodology should be discussed before the definitive purchase agreement is being negotiated, and preferably addressed at an appropriate level in the letter of intent.
Leaving the issue until late in the transaction can create unnecessary friction precisely when both parties are trying to get the deal closed.
Another frequent source of disagreement is not the target itself, but what gets included in working capital.
For example:
These questions can materially affect closing working capital.
The purchase agreement should therefore do more than state a target number. It should clearly establish the components of working capital, the accounting principles to be applied and the methodology for calculating the closing adjustment.
Where appropriate, a sample working capital calculation or illustrative schedule can be attached to the purchase agreement.
The objective should be simple:
Reduce the opportunity for either party to reinterpret the economics of the deal after closing.
Even when Buyer and Seller agree on which accounts constitute working capital, disagreements can arise over how those accounts are calculated.
A business may historically have applied certain accounting policies or estimates when determining inventory reserves, doubtful accounts, accrued expenses or other balances.
If a Buyer applies a materially different methodology after closing, the resulting working capital calculation may change.
That is why the purchase agreement typically establishes an agreed hierarchy of accounting principles for preparing the closing statement.
For Sellers in particular, understanding those provisions before signing can be important. What appears to be a minor accounting definition can ultimately affect the cash received from the transaction.
In many transactions, the final working capital number cannot be established until after closing.
The parties therefore agree upon an estimated amount at closing, followed by a post-closing true-up once the closing balance sheet is prepared.
Typically, the purchase agreement will establish:
Unresolved accounting disputes are often referred to an independent accountant acting in the capacity specified by the purchase agreement.
This mechanism is intended to determine the final purchase-price adjustment, not to reopen the transaction.
Clear drafting and careful financial analysis before closing can significantly reduce the likelihood that the parties ever need to use that dispute process.
Business owners understandably focus on the headline valuation when considering the sale of a company.
But, enterprise value is not necessarily the same thing as the cash ultimately received by the seller.
Debt, cash, transaction expenses, earnouts, holdbacks, escrows and working capital adjustments can all affect the final economics.
Working capital deserves particular attention because it sits at the intersection of valuation, accounting, negotiation and purchase-agreement drafting.
My experience over more than 25 years of M&A transactions has reinforced a simple lesson:
The best time to negotiate working capital is before it becomes a problem.
Understand the company’s historical working capital requirements. Identify unusual items. Agree on the methodology. Model the potential adjustment. And make sure the working capital provisions reflect the commercial deal the parties actually intended.
A strong M&A process is not just about negotiating the highest headline price.
It is about protecting the value behind that price.
At Minerva Valuations, our M&A Advisory team works with business owners throughout the transaction process, from understanding value and preparing a business for market through buyer negotiations, due diligence and transaction execution.
If you are considering selling your business and would like to understand how working capital or other deal terms could affect the value you ultimately receive, we would be pleased to have a confidential conversation.
Watch for Parts 2 and 3 of my three-part M&A Deal Economics series, where we will examine earnouts and the choice between an asset sale and a share sale, and why, in M&A, the structure and terms of a transaction can be every bit as important as the headline purchase price.
