Sellers that are unfamiliar with the M&A process are often surprised and dismayed to learn only after the purchase price has been negotiated that there are price adjustments that can reduce the available proceeds at closing.
The most common of these is the so-called working capital adjustment.
What is the working capital adjustment?
For the non-accountants out there, working capital is a company’s current assets less its current liabilities. It is a measure used to gauge short term financial health and liquidity of an enterprise. In a normal business context the working capital calculation includes the company’s cash. However, M&A transactions are often structured on a “cash free/debt free” basis. In practical terms, this means that the seller may retain all the cash on the company’s balance sheet, but must deliver the target company to the buyer at closing free of all long term debt and with an agreed upon level of (non-cash) working capital.
Buyers determine the value of a target company based on a multiple of its cash flow (usually measured as earnings before deducting expenses for interest charges, income taxes, depreciation and amortization or “EBITDA”). The rationale for the working capital adjustment is because the buyer’s valuation contains the inherent assumption that the target will be financially capable of operating post-closing in the same manner as before the sale without the need for additional capital. If the buyer ends up having to infuse more capital to stabilize the target company, the implication is that the negotiated value of the company was higher than its actual value and the purchase price will be reduced by the amount of the working capital “shortfall.”
How is the correct amount of working capital established?
The actual working capital threshold is a product of the buyer’s due diligence review of the target and negotiations with the seller. Conceptually, it should be the amount of working capital that is sufficient to operate the target company as it has operated historically for one full operating cycle after closing (usually a fiscal year) without the need for additional capital. In order to smooth out fluctuations in working capital due to seasonality and business cycle effects, the parties usually seek to establish the average working capital amount over a trailing 12-24 month period rather than pegging the threshold to a particular point in time.
If the target company has been undercapitalized historically, the buyer will require a working capital threshold that is higher than the target’s pre-closing levels. Likewise, if the buyer plans significant changes to the business, further adjustments to the target’s customary working capital level may be negotiated. The question of who should bear the financial cost of any material deviation of the working capital amount required at closing from the pre-closing level is often the subject of intense negotiation between buyers and sellers. Capital-intensive businesses that have “heavy” balance sheets with significant amounts of equipment and inventory tend to have higher working capital requirements than services and technology companies.
If you are considering selling your company, make sure to work with your financial and legal advisors early in the process to get a good handle on your company’s working capital needs so you can avoid an unanticipated (and unpleasant) negative working capital adjustment on closing day!
This post was written by David Jaffe