When a buyer values a target company, the buyer’s valuation is based on the target company’s financial condition on a specific date. In most instances, several months pass between that initial valuation date and the closing date, when the buyer acquires the target company. Purchase price adjustments need to be negotiated to reflect changes in the target company’s financial condition between those two dates.
According to the American Bar Association’s 2011 Private Target Mergers & Acquisitions Deal Points Study, 82% of private company acquisitions in 2010 included purchase price adjustments.
Related: Why Negotiate Working Capital?
The most common type of purchase price adjustment is a working capital adjustment. The target company’s working capital is constantly fluctuating. Working capital adjustments safeguard the buyer’s investment by discouraging the seller from decreasing the target company’s working capital before the closing. Working capital adjustments can also protect the seller by ensuring that the buyer does not receive a windfall if working capital increases between the buyer’s initial valuation date and the closing date.
What is working capital?
By definition, working capital is current assets less current liabilities. Ultimately, it measures a company’s ability to pay off existing debts quickly. The current ratio measures net working capital levels in terms of ratio analysis. A result less than one is generally considered unfavorable as it indicates that the company does not have the short-term assets necessary to pay off short-term debt quickly. In a business appraisal, your appraiser will typically consider a “normalized” level of working capital as part of their analysis.
A “How-to Guide” Regarding Working Capital in M&A Deals
In purchasing (or selling) a company, parties will often agree on a price for the transaction and then start moving towards the closing. And then… get derailed when the issue of “what is being sold?” is invariably raised. At the outset, it’s essential to define what is being sold and account for any closing adjustments or “true-ups.”
Step 1: (Re)-defining Working Capital for M&A
Whereas the accounting definition is clear (Current Assets less Current Liabilities), in M&A, things can get a little murkier. Consider that for many lower middle market companies that their balance sheet is a little “out of whack”. More often than not a company will be completely debt free, and instead be “over capitalized” but keeping rainy day cash on the balance sheet. If we simply used the accounting definition of working capital, the amount included in most sales would be dramatically overstated. How does that impact a seller? It’s essentially a reduction in purchase price!
Another complexity: many small business transactions are structured as asset sales. (check out Quantive’s guide for Asset Sales.) This means that the deal is “ala carte” – with the buyer only purchasing a portion of the balance sheet. Often a buyer won’t buy the entire balance sheet, meaning that the seller retains those assets (or liabilities). For this reason, it’s important to delineate precisely what will be transferring.
As an example, see the table below.
|Cash and Equivalents
|Seller retains excess amount or purchase price adjusted
|“Fresh” and salable inventory only
|Loan to Shareholder
|Current Portion LT Debt
|Seller to pay at or before closing
Step 2: Define the “Peg”
Working capital levels fluctuate every single day. Further, a business often maintains excess liquidity to cover short-term fluctuations in cash flow requirements. When a deal is struck, the purchase price is often predicated on financial performance at a point in time. So the questions are:
- How much working capital is on hand (and thus required to be on hand at closing)?
- How much is required?
You can see where this is going – this is a negotiation. Of course, there are many ways to do this, and most NWC pegs are expressed in terms of a dollar value (the “purchase price is $10m, which will include $100k in working capital). One technique we like is converting networking worth into days. This tends to be an exact point that can help facilitate discussions. Going into a negotiation, you might calculate days of NWC on hand for the last month, last quarter, and last year. You might then express your NWC peg as 30-60-90 days on hand.
Step 3: The True-Up
While, in some cases, the NWC Peg may be trued up at the actual closing, it’s probably more likely that the adjustment will be made post-closing based on a final balance sheet. Accurate up adjustments usually come in one of a couple of flavors:
- Dollar for Dollar. Any variation between the peg and the closing balance sheet results in an adjustment.
- De minimus Adjustments. Adjustments are only made over a certain threshold amount.
- Capped Adjustments. Adjustments are made only up to a certain capped level.
Working capital is an ever-changing number. It will likely not be the same on the day you first consider the purchase/sale of a company and on the date you eventually close the deal. It is essential for both the buyer and the seller to carefully consider the terms negotiated regarding its working capital. These specifications will stabilize the deal for whatever date the closing goes through and hem in the transaction details so that both parties know what they are getting.