The Dollars in the Details

{Working Capital: def: current assets minus current liabilities}. Sounds simple, right? Almost never. When the business sale closes, who gets what piece of this pie? It’s an often overlooked area, and one where it literally pays to consult your deal advisors and do the analysis early in the process. We’re not talking about legal hypotheticals & risk management folks, we’re talking about tens, sometimes hundreds, of thousands of dollars.

Valuations and LOIs impliedly, but rarely explicitly, assume an “adequate” or “normal” amount of working capital (WC). Buyers want to ensure the business has enough WC to meet short term operating requirements, without having to infuse additional cash. Sellers, on the other hand, want to take all the cash out of the company, or at least get compensated for all business they've already performed. But what is “adequate” or “normal”, and how do we structure the deal to take into account a moving target?

The most common approach is to structure the deal with a “Target” WC amount, with a post-closing adjustment, dollar-for-dollar, based on a “look-back” balance sheet retro to the date of closing. This captures such things as payables arising before the closing but not invoiced/received until after.

Ok, that sounds straightforward enough, but what about setting that “Target”? WC needs vary greatly from company to company, and often within a company from season to season or year to year. Here are some factors to consider with your broker and CPA:

Seasonality. In businesses with highly seasonal sales, WC will vary significantly. If, for example, a transaction closes when the cash from holiday sales have already come in (and gone out to the owner), and new inventory/materials need to be acquired, what might otherwise be “normal” WC (i.e. looking at the past few months) is probably not “adequate.”
Growth. If the company is on a growth trajectory, its WC needs are likely growing along with sales, and historical WC is not likely a good indicator.
Replacement Cycles. If, based on a buyer’s due diligence, they determine that the business needs new key equipment or other major expenditures, that should be factored in to the WC analysis. One common approach is to look back several years, in some cases as much as ten, and consider the nature of the equipment, the useful life, and normalize/average replacement costs over that period.
Receivables. Is the A/R being sold? If so, is there a “guarantee” mechanism (i.e. Buyer will pay a maximum of 90% of value of A/R on the balance sheet at closing; or Seller will be charged back for any A/R not received within 90 days of closing). This should be factored into your approach to WC requirements and post-closing adjustment.

Another issue is the actual mechanism for making the “look back” adjustment – how will it be paid? If part of your transaction is a seller holdback note, that is often the best vehicle; simply adjust the note balance based on the final calc. If not, you may need an escrow agent with well-drafted escrow instructions. And what about disputes over the calculation? You’ll want carefully constructed provisions providing for selection of independent CPAs to settle issues. Finally, whether you’re the buyer or seller, you’ll want to set the framework for this up front, in your LOI, or at least leave some flexibility of language that doesn’t subject you to being perceived as “changing the deal” when it rears its head again later. And well before that, you'd be wise to tap a CPA with solid cash flow analysis/modeling skills to help you get a handle on the WC and prepare to make your case for what is "adequate."

This post was originally written by Mr. Cook as a guest for the IBA Blog.