Working capital adjustments are required when a going concern business is acquired by way of a share purchase. This is the case for two main reasons: (i), because working capital changes every day as revenues are generated and supplier and payroll payments are made, and (ii), because working capital is easily manipulated in a material way (for example, the seller could withdraw cash before closing or accelerate receivable collections or delay payables, potentially damaging trade relationships).
A working capital adjustment is typically settled some time (say 90 days) after closing and may be part of other purchase price adjustments, all usually settled within one year.
Working Capital Definition and Components
Simply put, working capital is current assets minus current liabilities and is the liquid part of the balance sheet (i.e. items that are settled in less than one year). It is where revenues are collected and suppliers are paid and it includes cash (or access to cash in the form of short term investments, or conversely, a bank operating line).
Working capital can be measured on a net basis or as a ratio. For example, if current assets are $1M and current liabilities are $750k then net working capital is $250k and the working capital ratio is 1.33. In this case there is positive working capital. If current liabilities are greater than current assets then the company is said to have negative working capital.
Items requiring attention in an acquisition include:
- Cash; what is the right amount to support the business
- Accounts receivable; typically accounts receivable aged greater than 90 days are not recognized;
- Inventory; it must be current, sale-able and of an appropriate size;
- Any stretched accounts should be examined for its cause and the potential impact on the customer /supplier relationship.
- Taxes payable; are all taxes accounted for?
- Deferred or unearned revenues; deferred revenues are classified as current liabilities and are revenues collected where the product or service has not yet been delivered. Depending on the type of revenue (for example product sales versus support or warranty revenue), deferred revenue may represent differing levels of contribution margin.
When do working capital adjustments apply?
Working capital adjustments apply when a business is being bought as a going concern by way of a Share Purchase Agreement. However, going concern businesses can also be bought in the the form of an asset purchase where the cash held in the business would not be part of the transaction and thus not be an issue.
What is the right level of working capital on closing?
In traditional businesses, a large working capital number or ratio means the business can weather unforeseen shocks, but it will also reduce the company’s return on assets (sometimes called a lazy balance sheet). Negative working capital is not sustainable for traditional businesses but for business models where services are prepaid it could actually be normal.
Most M&A deals are negotiated on a cash-free and debt-free (CFDF) basis. In simple terms, this means the seller keeps excess cash and pays off the funded debt at the time of the sale of a business. However, with respect to working capital this can get tricky. Buyers and sellers should seek to establish a “normal” level of working capital on closing of a transaction. This normal amount may not be the “right” amount on the day of closing but is typically the average level of working capital throughout an agreed period of time. A reasonable rule of thumb would be to assume the same time period that the valuation of the business is based on.
The following business characteristics will affect the normal working capital amount:
- Growth: generally speaking, a fast growing company will need more working capital to fund receivable and inventory growth than a no-growth business;
- Seasonality: If the business is seasonal (for example, heavily dependent on Christmas sales) then, around Christmas working capital will be high, initially with inventory and then after Christmas receivables;
- High Working Capital Business Model: if payables are required to be paid quicker than receivables are collected (like staffing companies that typically have to pay contractors every two weeks while they get paid monthly) then working capital will need to be high;
- Low Working Capital Business Model: if cash is collected quicker than it is paid (like an online referral business that collects cash, has no inventory and does not have to pay its suppliers for 30-60 days) then working capital can be low.
- Non Operating Issues: private companies may not manage their working capital as efficiently as they can. They may leave cash in the business for tax reasons. This will inflate working capital, so it is important to determine the level required by the business.
To determine the right level of working capital, cash flows should be examined for cyclicality and fluctuations for a minimum of the last 12 months. Sometime before closing, a target closing balance sheet should be prepared reflecting a normal level of working capital. Excess cash is typically distributed before closing and the actual level of working capital is not finalized until some time after closing. If it is higher than the normal level of working capital, the seller receives the excess or, if below the agreed upon amount, the buyer is due a credit. In most cases reserves are held in escrow for the purpose of funding working capital adjustments.
Example of a Net Working Capital Adjustment Clause
The following is an example of a working capital adjustment clause.
“The Purchase Price is based on a Net Working Capital Target Amount of $1,000,000 as illustrated in Exhibit A – Estimated Closing Balance Sheet, attached hereto. To the extent that the Net Working Capital on the date that the purchase transaction closes (the “Closing Date”) exceeds the Net Working Capital Target Amount, such excess shall be payable to the Seller. To the extent that the Net Working Capital on the Closing Date is less that the Net Working Capital Target Amount, such difference shall be deducted from the Purchase Price.
The Net Working Capital Adjustment is estimated as of the Closing Date in Exhibit A, and the cash paid on the Closing Date will be adjusted based on that estimate. The Net Working Capital Adjustment will then be finalized and any difference vs. the estimate paid as appropriate within 90 days of closing. All calculations of Net Working Capital shall be made using GAAP consistent with past practice.“
As every business and every seller is different, working capital will always be a point of negotiation in an M&A transaction. The working capital issue is more complex than one would think. The amount of capital that is required for working capital will affect the value of a business. Once you fully understand the cash flows in a business you can settle on a reasonable closing level of working capital.
Other Purchase Price Adjustments
Working capital adjustments are part of a bigger basket of purchase price adjustments. Other adjustments may be made for breaches of reps and warranties. Purchase price adjustments are most commonly settled by way of the hold-back.
Recommended Further Reading
For more on various types of private capital, see: Navigating the World of Private Capital
For a more on revenue quality, see: Revenue Quality: What Does it Really Mean?