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, which is 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.
The most common type of purchase price adjustment is a working capital adjustment. The target company’s working capital is always fluctuating. Working capital adjustments safeguard the buyer’s investment by discouraging the seller from decreasing the target company’s working capital prior to 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 simply current assets less current liabilities. Ultimately, it is a measure of a company’s ability to quickly pay off current debts. In terms of ratio analysis, the current ratio measures net working capital levels. A result less than 1 is generally considered unfavorable as it indicates that the company does not have short term assets necessary to quickly pay off short term debt. 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 actually being sold?” is invariably raised. At the outset it’s important to define what is actually being sold and account for any closing adjustments or “true ups.”
Step 1: Re-defining Working Capital for M&A
Whereas the account definition is clear, in M&A things can get a little more murky. Most small business transactions are structured as asset sales. (Quantive has a guide for this.) This means that the deal is “ala carte” – with the buyer only purchasing a portion of the balance sheet. Often times a buyer won’t purchase the entire balance sheet, meaning that the seller retains those assets (or liabilities). For this reason it’s important to delineate exactly what will be transferring.
As an example see the table below.
|Cash and Equivalents||x||Seller retains excess amount or purchase price adjusted|
|Inventory||x||“Fresh” and salable inventory only|
|Loan to Shareholder||x|
|Current Portion LT Debt||x|
|Tax Liability||x||Seller to pay at or prior to 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 actually required?
You can see where this is going – this is a negotiation. There are a multitude of ways to do this, of course, 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 net working capital into days. This tends to be a very tangible 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. True 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 important to both the buyer and the seller to carefully consider the terms negotiated regarding the company’s working capital. These specifications will stabilize the deal for whatever date the closing goes through and hem in the details of the transaction so that both parties know what they are getting.