It is Crucial to Understand the Impact of Working Capital and Other Adjustments in a Transaction
Most transactions are negotiated on a cash-free and debt-free basis. Simply applied, one could assume that the seller keeps all cash and repays all debt at the time of the sale of a business, and there is nothing more to it. But unfortunately, it is not as straightforward.
Having executed many different transactions, we are still unable to agree that there is a standard or a typical scenario. Every transaction appears to bring additional points of reference rather than simply allowing us to leverage what we have learned in previous transactions and applying it to the next.
Whether buying or selling a business, there are usually adjustments required to get the deal to close on a cash-free and debt-free basis, and these adjustments may significantly impact the economics of the transaction. Consequently, it is crucial to understand and anticipate how such adjustments will impact the transaction price.
The information contained in this note will assist in providing you with an understanding of the concept of working capital and other adjustments in a cash-free debt-free transaction. This information will allow you to have a meaningful and structured conversation between the buyer and the seller, under the premise of a transaction that is fair for both as it relates to working capital and other adjustments in a cash-free debt-free transaction. With this information in hand, you can then determine how you want to proceed in the negotiation phase of the transaction.
The following attempts to provide answers and guidance regarding working capital and other adjustments in a cash-free debt-free transaction:
- Done properly, neither the buyer nor the seller should gain or lose money from the working capital and other adjustments
- An understanding of working capital and other adjustments at closing will allow buyer or seller in making conscious choices
- Addressing the working capital and other adjustments at the appropriate time will lead to a more productive process
- A proposed process to settling the working capital and other adjustments
Now with the details:
- done properly, neither the buyer nor the seller should gain or lose money from the working capital and other adjustments
Working capital and other adjustments are designed to ensure there are enough short-term operating net assets in the acquired business to allow it to pursue its regular activities post-closing.
Should that not be the case, then the buyer or the vendor would need to be compensated if there is too little or too much short-term net operating assets, respectively, in comparison with what is needed to support the business’s ordinary course of operations.
In other words, the working capital adjustment should be a zero-sum game. If the vendor is selling at a time when the company’s working capital is exceptionally high, meaning that significant investments were made by the seller pre-closing to build the working capital, then he should be compensated. However, if the sale is made at a time when the working capital is exceptionally low, then the purchaser should be compensated.
There is an overarching premise that neither the buyer, nor the seller, should be making or losing money from the working capital and other adjustments, where the trade-off to the working capital adjustments is the corresponding cash (i.e., however high, or low) that was invested in the business or collected from the business pre-closing.
- an understanding of working capital and other adjustments at closing will allow the buyer or the seller in making conscious choices
The concept of cash-free debt-free cannot be assessed in isolation to determining a normal working capital that should be delivered at closing.
In determining what is a “normal” working capital level that should be delivered at closing, buyer and seller should first identify which balance sheet accounts are part of that calculation, and which ones are not.
The core reason for the exercise is that the relevant cash and debt account balances are those at the closing date.
Once these accounts are classified as cash or debt (and debt-like items), then they are either excluded from the business being sold or, if not excluded, they will directly affect the purchase price.
Cash and debt accounts should be looked at separately from the working capital.
As it relates to working capital, the added dimension is the analysis required to determine what is considered “normal” working capital to be delivered at closing, and any difference to the actual working capital delivered should impact the purchase price.
In other words, the relevant cash and debt balances in the exercise are the balances at closing, whereas the relevant balance of working capital is what should be delivered at closing.
As a simple example, let us assume that the company being sold is in the business of winter accessories (i.e., one operating cycle annually). Throughout the annual cycle, the collection is being designed, inventory is built up and suppliers are gradually getting paid, and lastly, as inventory is being shipped, customers are being invoiced and receivables collected based on the agreed payment terms.
The company EBITDA is $3 million, and the average monthly working capital is $1.5 million. It is reasonable to assume that the company should be sold with a working capital of approximately $1.5 million, which will allow the buyer to generate an EBITDA of $3 million, a number likely to have been used in the valuation of the company. However, depending on the time of the year, the working capital may be as low as $400k and as high as $3 million.
The working capital adjustment is intended to make the time the transaction is made irrelevant, i.e., a zero-sum game for the buyer and seller. As the seller, you should be compensated if you sell the company at a time when the working capital is at its higher, and as a buyer, you should be compensated if you buy the business at a time when the working capital is at its lowest.
Jocelyn Dumas, Managing Director- M&A Keira Capital Partners Inc.
Learn more in our Treatments of Working Capital ebook by Jocelyn Dumas. Complete the short form below to receive the ebook via email.