In this short article, I will discuss the challenges and misunderstandings that can arise around working capital during an M&A transaction. If left unaddressed, the nature and handling of working capital in a transition can cause an otherwise solid deal to fall apart. However, through mutual understanding these issues can be avoided.
Every business needs sufficient capital to operate successfully. An astute manager understands the role of cash, receivables, payables, inventory, and prepaid items in navigating the daily ebb and flow of business operations. However, during an M&A transaction working capital can often become a contentious issue.
Let’s start with the definition of working capital that I most often use in M&A and it’s quite simple: current assets less current liabilities.
In a stock-based sale, all working capital balances remain with the business at the time of sale. Often times, a seller feels entitled to net working capital because they worked to generate those cash flows. However, the buyer views the working capital as needed to operate the company in the near-term.
In an asset-based sale, the seller retains most working capital accounts and the buyer essentially starts with a blank slate. However, there may be some expectation that the seller will leave the buyer some net working capital. The amount is subject to negotiation and disagreement.
The issue (with either type of sale) is further complicated because working capital accounts can fluctuate during the normal operations of a company and may have abnormally high or low balances at the time of transition to the new owner. The differing views and potentially volatile balances could cause a major disagreement during due diligence and could cause the deal to fall apart.
In order to successfully address working capital concerns during an M&A deal, I believe there are some keys that sellers, buyers, and professional advisors should keep in mind throughout the transaction.
During the initial valuation, I typically include how we plan to handle working capital accounts during the pricing.
- For inventory-heavy companies, I typically specify that inventory is separately negotiable. Most often, during the final negotiation, the buyer purchases the inventory at a discounted amount.
- For non-inventory working capital accounts, I typically advise sellers that a buyer expects to retain a normal level of net working capital at the time of transition and that any deviation from that normal level will be subject to negotiation. I most often define “normal” as the average daily (or monthly) balance over the previous twelve months.
Each negotiation is a give and take along many aspects of the deal. I think that sellers, buyers, and professional advisors need to worry less about winning the negotiation and focus more on understanding the other person’s perspective.
- A seller should understand that the buyer is making a significant cash investment to purchase the company and may have genuine concerns over short-term cash flows.
- The buyer should understand that the seller has worked hard to build his or her company and that each dollar of working capital can feel meaningful to the seller.
- The professional advisor should understand the both the buyer and seller want a fair deal. It may be important for the advisor to offer a compromise that works for both parties.
Do the Math
Oftentimes, it is surprising how little impact working capital can have on the real value of a deal. As an example, if the sales price on a deal is $10M, it’s important to avoid arguing over a $100,000 disagreement in working capital. Split the difference 50/50 and be done! Of course, it’s not always so simple. In the process of negotiating working capital, calculate the impact on the buyer’s expected rate of return. If the buyer already has low rate of return, the seller may need to be flexible on working capital… and if the rate of return is high, the buyer should be more flexible. A professional advisor should be able to quantify working capital’s impact on ROI. Oftentimes, the “right” solution may emerge through a little number crunching.
At the end of the day, working capital can be a contentious aspect of the negotiation, but with a little perspective a professional advisor can help the buyer and seller navigate any disagreements.