How arriving at Working Capital Peg is critical for the success in a M&A deal?

• During the acquisition when the buyer decides to acquire the target after doing valuation, one of the most important terms put in the LOI would be that the buyer should have reasonable working capital post acquisition to ensure continuity in business operations.This implies that the buyer would not inject any funds from his end or take a revolving credit loan to finance any short flow in the acquired business.
• This condition is extremely important for Financial acquirers like Private Equity firms who generally take loans from bank to fund their acquisitions.
• Generally most of the acquisitions are negotiated at Cash Free Debt Free basis at closing.This means that seller is required to close any outstanding debts from his end and at the same time allowed to withdraw any excess cash in the balance sheet at the closing of the deal.There can be situations where buyer is allowed to take the cash and also absorb any debts on behalf of the seller.This will depend on how the transaction is structured between the buyer and seller.

Why Working Capital calculation is important?

• When the buyer values the target company then the valuation is arrived based on financial information available to buyer at that time.Once the buyer interest for the bid along with the purchase price is accepted by the seller, then the seller gives exclusive access of its financial records uploaded in the data room for the buyer to conduct a detailed due diligence.
• The seller has an advantage of knowing end to end information of his business.Hence the seller can manipulate the Working Capital cash flow and increase the EBITDA in order to get a higher purchase price from the buyer.For instance, at prior closing of the deal, the seller can aggressively collect any outstanding receivables from its customers by offering them a discount and at the same time delay payments to its vendors or default on its payments.When the transaction is negotiated at debt free cash free basis, the seller can sweep this cash prior to closing.When the buyer takes over the business he is put in an uncomfortable position and required to pay vendors but does not have funds as the seller had withdrawn the cash from receivables.Hence the buyer needs to either put it's own funds or borrow funds to settle liabilities like vendor payments or even employee salaries.

Working Capital Definition

• As per the accounting terms, Working Capital is the difference between Current Assets and Current Liabilities.
• When the deal is negotiated at Cash Free Debt free basis, the Working Capital does not include Cash, short term debts like Note payable as well as accrued interest expenses on debts.
• In some cases what constitutes Working Capital can change from one deal to another as the buyer and seller can include or exclude other components in Current Assets and Liabilities. In some cases, current assets like Prepaid expenses or current liabilities like Income tax payment or deferred revenues can be excluded when arriving at Working Capital.
• The buyer would be interested in the operating cash flow of the target business.Hence the Working Capital adjustments that the buyer would focus on are:
• Account Receivable
• Inventory
• Account Payable

Let us look at each of the above item and adjustments done by buyer and seller.

Account Receivable

• This is primarily the outstanding payments that the seller needs to collect from the customer.The buyer looks at the payment terms and conditions offered by the seller to its customers and does an historic analysis along with industry benchmarking to assess if payment terms offered are as per industry standards.
• In some cases the seller offers extended payment terms in order to get more revenues from customers.This is not encouraged by the buyer and is accounted when doing Quality of Earnings study during due diligence.In some cases the seller would not have made a provision for bad debts in its balance sheet.Hence there might be situations where the seller is expecting a payment from the customer for more than 3 months and had not written it off as bad debts.This will artificially increase the Working Capital.All these anomalies are detected during due diligence and adjustments are made to the Working Capital to arrive at Normalized Working Capital which is the buyer is confident of.
• The buyer also does an Ageing analysis of seller Account receivables and might not be interested to collect any amounts that has exceeded 90 days.In such cases the buyer request the seller to collect these amounts from customers before closing or the buyer will adjust the targeted Working Capital accordingly.

Inventory

• This is the stock at hand available at seller to respond to market demand.During due diligence the buyer would do a detailed analysis of seller inventory to check if sellers has an optimum stock in hand and if the inventory in hand aligns to the growth in revenues.In some cases the seller would not invest any money in buying inventory and retains these savings as cash prior close.Post acquisition, the buyer needs to put additional funds to buy inventory to respond to customer demand else there will be loss of revenues. The inventory level maintained depends on business and industry the seller operates in.In cyclical business like Retail the inventory levels will vary depending on the timing.During holiday season the inventory would be maximum and during off season there will be less inventory. The buyer needs to keep this in mind while conducting due Diligence to arrive at Target working capital peg.

Account Payable

• This is the payment that the seller owes to its vendors.To increase operating efficiency, collection of receivables must be quicker than payment to the vendors.This also means the business is in a good position and has high bargaining power over its customers and suppliers.
• In many cases, prior to the closing of the deal, the seller delays payments or default on payments to vendors.Post acquisition, the buyer is required to not only do these payments but also restore the relationship with suppliers who would have alienated the seller for delaying or defaulting on their payments.

How to arrive at Net Working Capital Peg?

• The buyer and the seller would arrive at Target Working capital that the seller needs to maintain in its balance sheet at the time of closing.
• For instance the buyer would arrive at Purchase price of $60M subjected to the target working capital of $10M.Any deviations by the sellers on the working capital value in its balance sheet at closing will have a dollar to dollar adjustment in Final Purchase price.
• For instance taking the above example, if the Target Working Capital maintained by the Seller is $8M then the final purchase price would be adjusted to $58M and if the Target Working capital is $12M then the final purchase price would be increased to $62M.
• To arrive at the Working Capital peg, the most common method is to calculate the average of last 12 month Working Capital numbers of the seller.This will also take into account any cyclical variations in numbers.
• In cases where the seller revenues are growing at a higher rate then this approach may not work as the Working capital requirement should also increase linearly with revenue growth.In this case average of last 3 months of Working capital numbers are taken. In other cases, the buyer may look at seller future projections and arrive at Working capital number based on 3 month historical average and 3 months average of future projections.

Working Capital adjustments between signing and closing

• After the buyer and seller arrives at the Target working capital, then subjected to the agreement of other conditions, the definitive agreement is signed.
• There will be time delay between the signing and closing as buyer and seller are required to get regulatory approvals. During this time delay, the Working capital numbers might change due to changes in market or there could be changes in payment conditions between customers and seller.In some cases, the buyer would instruct the seller not to withdraw any cash or do any changes to the business between the signing and closing and any such transaction by seller would require prior buyer consent.
• At the time of closing, the seller balance sheet would be audited to arrive at final Working Capital numbers.Any changes in the final numbers with the Target Working capital would be adjusted in the Final Purchase Price.

Conclusion

• Arriving at Working capital peg is extremely critical for both buyer and seller in a M&A deal.If not done properly both of them stand to lose.
• If not done properly,The seller might lose by keeping unnecessary cash in the table while the buyer stands to lose as be might need to put additional funds to true up the Working capital.
• To avoid this, negotiations on Working Capital needs to start very early in the transaction preferably during LOI stage itself.What constitutes Working capital and what should be the target Working capital at closing should also be the subject of negotiations between the buyer and seller.
• Any disputes between the buyer and seller on the Working capital adjustments during closing can be resolved through arbitration but it is recommended that seller and buyer recognize any conflicts in advance and decide not to proceed further to avoid unnecessary expenses incurred in Due Diligence and SPA drafting.