Understanding Working Capital10 July, 2018
In most M&A transactions, the parties arrive at a purchase price by multiplying the target company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) by an agreed-upon multiple. While this is generally true, it’s only part of the story. Buyers will also typically include certain protections such as indemnification provisions, a third-party escrow or other holdbacks, and very often a requirement for a minimum amount of “working capital” on the balance sheet when the deal closes to ensure there are no immediate liquidity issues.
A working-capital hurdle is a predetermined working capital amount that is assumed in the purchase price. For example, a deal might include a purchase price of $100M based on the seller’s delivery of $15M of working capital at closing. If the seller delivers less than the agreed upon working capital amount at closing, the purchase price will be adjusted accordingly.
It’s commonly understood that a working capital provision in an M&A transaction is there to protect the buyer. A buyer doesn’t want to pay twice: Once to buy the business and then to have to inject capital post closing in order to keep the company running. However, according to Ben Boissevain, Managing Partner at Ascento Capital, sellers do themselves a massive injustice by failing to understand the working capital provision in their transaction fully.
In our "Negotiating Working Capital" webinar on July 18th, Ben explained why the working capital issue can be a highly complex and contentious part of M&A transactions, and how failing to fully understand the ramifications of the working capital hurdle has the potential to cost the seller millions post-closing.
In advance of the "Negotiating Working Capital" webinar we sat down with Ben and asked him what sellers need to know about working capital provisions and what attendees of the webinar would learn.
Q: Why is understanding the working capital provision in a transaction important for the seller?
Ben: During any M&A transaction a negotiation takes place. That negotiation will, of course, revolve around price, but it will also include other provisions, such as having a “reasonable amount of working capital” on the books at the time of closing. That’s perfectly fine, but further down the road, the buyers are going to define what “reasonable” is because they want to ensure that the seller has enough cash and cash equivalents on the balance sheet at the close of the deal to continue the business. So the question becomes, how much is reasonable?
Sometimes sellers are surprised by this question and there’s a disconnect because working capital is dynamic and fluctuates based on a number of influences. So it’s beneficial to the seller to examine their working capital before negotiations even begin. They should look at it on a three-month, six-month and twelve-month basis to understand the fluctuations and to determine what amount is reasonable and most beneficial.
Q: How is working capital calculated? Does it depend on the industry?
Ben: Some industries are more working capital intensive than others. Typically, if a company is growing rapidly more working capital will be required. But the calculation is pretty standard. Working capital is simply the company’s current assets minus current liabilities. However, those numbers change all the time based on when the company pays vendors and when they collect from customers. That’s why we generally look at an average over the span of twelve months.
Let’s say that the average turns out to be five dollars. That’s what it’s been taking to run the business, and that’s what it should require moving forward. So when the deal closes the buyer expects to see five dollars of working capital on the balance sheet. Typically, what happens is that at close seven dollars of the negotiated price will be put into escrow and a month after closing accountants will be brought in to calculate the current working capital. If it turns out that there's only four dollars of working capital on the balance sheet, then the negotiated price will be discounted by one dollar. So, of the seven dollars in escrow, the seller would only get six. Of course, if there’s more than five dollars on the balance sheet then the seller benefits.
Q: What can sellers do to more fully understand the working capital issue and breech the disconnect with buyers?
Ben: During an M&A transaction there are many holdbacks that end up in escrow that sellers are often not prepared for. There can also be a disconnect on how working capital should be defined. If you have a very fast-growing company (typically requiring more working capital) a buyer may think that a twelve-month working capital average is too low. They’ll prefer a three-month average because sales have been increasing and a three-month average more accurately captures what the working capital has been recently. The seller, in order to protect itself, obviously would prefer the lower twelve-month average. That’s why it’s important for the seller to do three, six and twelve-month averages to fully understand what their working capital has been historically and so that at closing the buyer doesn’t suggest a working capital amount that takes the seller by surprise. If the seller doesn’t do the calculations correctly and fully understand their working capital fluctuations, they can be caught by surprise, and it can cost millions.
Q: What are some of the pitfalls you typically see when incorporating working capital provisions in transactions?
Ben: The biggest pitfall for sellers is not having a clear understanding of what working capital is and how it will be defined. A very precise definition is required. It can get a little tricky and technical. Does the calculation include deferred taxes? Are there other liabilities included in the definition? The seller needs to understand a very comprehensive definition that they and the buyer both agree on. It’s not a bad idea to have a sample calculation based on the company’s actual numbers. Then the buyer and seller can sit down together and make sure they agree on the definition and how it will be calculated. That way there are no surprises.
The most critical step sellers can take is to prepare early. As soon as a buyer approaches, the seller should do working capital calculations. Working capital is a highly complex issue so if the seller is prepared and understands the complexity before negotiations begin, they’ll know the best outcome before the issue is even put on the table.
To explore more and receive sound advice from an expert, view the recording for the "Negotiating Working Capital" webinar today.