The Mother of All M&A Deal Killers
The title is a bit dramatic, but the fact is, disagreements between buyers and sellers on Working Capital are more common than not, and they really do result in deals dying on the vine.
This article is a very high-level piece intended for first timers to get up to speed with the basic concept of Working Capital to keep themselves out of trouble (you should always depend on your advisors to do the actual).
At the highest level it’s simple: sellers of companies don’t want to leave behind a bunch of valuable cash, AR, inventory or other liquid assets in their business, and buyers want to take over a company with as much of these assets as possible. During Covid, the situation has been exacerbated by the fact that business owners have generally been building extra high inventory levels—sometimes 3-4 times historical levels—to avoid supply chain issues that could choke their business. Getting that extra investment out of the business can be tricky on a sale, unless the right approach is taken by the parties at the table. This amount can in some cases equate to millions of dollars of extra proceeds to a seller at Closing.
Why don’t we just do the straightforward “working capital” formula we learned in Grade 10 Business class and call it a day?
Using that simple formula [ Working Capital = Current Assets – Current Liabilities ], will get you an “A” on your quiz, but on its own, will not be very helpful in making sure a business is left with the right amount of assets to operate after closing an M&A transaction.
The problem lies in the fact that the basic Working Capital formula is 100% accurate for only a snapshot in time, but it doesn’t tell us how much Working Capital a business needs to operate after Closing without the buyers having to put in a bunch of capital to pay the bills. The Working Capital formula also needs to be narrowed a bit to take items including, but not limited to: cash, taxes, receivables, payables, inventory, accrued expenses & prepaid expenses in order to calculate a “Net” Working Capital figure, which I will refer to as “NWC” here.
Rest assured, there is a trusted recipe to avoid Buyer/Seller
friction over Net Working Capital:
1) PEG IT;
2) MEASURE IT;
3) TRUE-IT UP!
STEP 1) PEG the historical Net Working Capital needs of the business.
This is the hardest part of the recipe. The basic idea is to use the NWC formula to calculate NWC at as many points as possible over a long period of time, and determine an average. We are looking to “peg” the NWC figure, based on historical data.
When advising clients, we typically run the NWC calculation on a monthly basis over a historical 24-36 month period, determine NWC average, and weight that NWC Peg towards the most recent 12 months. Major peaks and valleys in the monthly NWC calcs should be identified, discussed between the parties, and also factored into the NWC Peg. Other factors that need to be taken into account include: seasonality, large one-time sales or projects, etc.
The NWC Peg should be agreed to as early as possible
in the sale process—ideally included in the Letter of Intent.
STEP 2) MEASURE IT at Closing.
Now that we have done the hard work to get mutual agreement on the NWC Peg, we have to start the Closing process. We need to determine if there will be a payout of excess NWC at Closing to the sellers (or a hold back of any sale proceeds by the buyers to cover any NWC shortfalls). To do this, we need to compare the agreed upon NWC Peg with the actual Net Working Capital observed at Closing. Unfortunately, it’s nearly impossible to do that NWC calculation on the day of Closing, say September 30th, because companies typically don’t close the books off for several weeks after month end.
To facilitate Closing when the month end books are not closed, we calculate NWC at the end of the most recent month end for which financials are available (say August 31st), and then estimate from that what the NWC figure will be at Closing (say September 30th). Basically, add in all the major inflows and outflows expected over that one-month period, and compute the Net Working Capital Estimate at Closing. If the NWC Peg figure is less than the NWC Estimate, there is a NWC Surplus and the Seller gets paid the difference at Closing. If the NWC Peg is greater than the NWC Estimate, there is a NWC deficiency, and the Seller must leave some of their Closing proceeds on the table to make up that shortfall.
STEP 3) TRUE IT UP 60-120 days after Closing.
Remember in Step 2 where we were unable to calculate the 100% accurate NWC figure at Closing because the month end books were not yet closed? Well, its now several months after Closing and the books (should be) closed. Now we have the 100% accurate figures and we can see just how close our NWC Estimate was, and we can do any “True Up” payments to make up for any shortfall or surplus between the NWC Estimate and the Actual NWC at of the Closing date.
Remember, we are never adjusting the already
agreed upon NWC Peg at any point.
The NWC Peg has long been settled between the parties, and the only thing left to do is to move money back and forth between the buyer and the seller, the “True Up”, to make up for any differential between the NWC Estimate we did at Closing and the Actual NWC we determine months after Closing. When it comes time for True Up, if the final NWC calculations show that too much excess NWC was paid out to the Seller at Closing, they need to pay the extra back to the Buyer. If at True Up time the final NWC calculations show that the Seller wasn’t paid out enough of their NWC, then the Buyer needs to make a payment to the Seller to make up for that deficiency.
The Seller typically leaves a good chunk of their sale proceeds in escrow with legal counsel to satisfy any NWC shortfalls, which gets released to the Seller when the final NWC excess/surplus are calculated 60-120 days after Closing. In some cases, this can range as high as 20% of the entire purchase price left in escrow by the Seller.
As always, we insert our plug here…hire a veteran M&A Advisor to help you on your M&A transaction. The odds of a closing a deal go up dramatically when Advisors are on BOTH sides of a deal, and the extra cost is usually more than made up in the higher price attracted (or when your Advisor saved you a barrel full of cash by avoiding a poorly negotiated Working Capital payout).