The treatment of working capital can change what a seller receives by as much as a negotiated change in the multiple, and it receives a fraction of the attention. Two offers at the same price are not equal if one buyer expects to receive the receivables and inventory and the other does not. The question should be settled in the letter of intent, with a number or a formula.
What working capital is
In a transaction, net working capital generally means current operating assets less current operating liabilities. In practice this is accounts receivable plus inventory plus prepaid expenses, less accounts payable and accrued expenses.
Most transactions are structured on a cash-free, debt-free basis. The seller keeps the cash in the bank and pays off the company's loans, and neither is counted in working capital.
Two conventions
How working capital is handled depends largely on the size of the transaction.
Smaller Main Street sales. In many asset sales priced on a multiple of SDE, the seller retains cash and receivables and pays off the payables. The buyer acquires the equipment, goodwill and inventory. Inventory is frequently priced separately, at cost, based on a count taken at closing.
Under this convention the buyer starts with no receivables to collect and must fund operations until its own invoices are paid. The buyer's loan usually includes a working capital component for this purpose.
Lower middle market sales. In larger transactions priced on a multiple of EBITDA, the price assumes the business is delivered with a normal level of working capital. The reasoning is that the earnings being purchased cannot be produced without it. A buyer paying for $1 million of EBITDA expects the receivables, inventory and payables that generate it.
Neither convention is more correct. The difficulty arises when the parties assume different ones.
The peg
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In the second convention, the parties agree on a target amount of working capital, commonly called the peg. At closing, actual working capital is compared with the peg.
- If actual working capital exceeds the peg, the buyer pays the seller the difference.
- If it falls short, the price is reduced by the shortfall.
The adjustment is dollar for dollar. Its purpose is to prevent either party from gaining by timing. Without it, a seller could collect receivables aggressively and delay paying vendors before closing, then hand over a business short of cash.
Setting the peg
The usual starting point is the average month-end working capital over the trailing twelve months. An average smooths seasonality and one-time swings. Several refinements are then negotiated.
Seasonality. A landscaping company closing in May has very different working capital from the same company in December. The peg may be set by reference to the same month in prior years.
Growth. A growing business requires more working capital each year, so a trailing average may understate current needs.
Definitions. The parties must agree on which accounts are included. Customer deposits, deferred revenue, accrued vacation, sales tax payable and the current portion of debt are frequent points of disagreement.
Normalization. Uncollectible receivables and obsolete inventory are removed, and payables stretched beyond normal terms are adjusted.
A seller benefits from a lower peg and a buyer from a higher one. Each dollar of difference is a dollar of price.
An illustration
Assume a business is sold for $3 million with a working capital peg of $350,000. At closing, receivables are $420,000, inventory is $130,000, and payables and accruals are $240,000. Actual working capital is $310,000, which is $40,000 below the peg. The seller receives $2.96 million.
Had the letter of intent been silent, the buyer might have argued for a peg of $400,000 and the seller for $300,000. That $100,000 range would be negotiated late in the process, when the seller's leverage is lowest.
The true-up
Because final figures are not available on the day of closing, the adjustment is made in two steps. The seller delivers an estimate shortly before closing, and the price is adjusted on that basis. Sixty to ninety days later, the buyer prepares a final calculation. Differences are settled in cash, often from a small escrow established for the purpose. The agreement should specify the accounting methods to be used and provide that disputes go to an independent accountant.
Inventory deserves separate attention
In inventory-heavy businesses such as distributors, retailers and manufacturers, inventory may be the largest single item. The parties should agree on how it will be counted, who will attend the count, how it will be valued and how slow-moving or obsolete items will be treated. A common approach values saleable inventory at the lower of cost or market and assigns no value to items with no sales in the prior twelve months.
Common mistakes
- Comparing offers by headline price without confirming what each buyer expects to receive.
- Signing an LOI that refers to "normal" or "adequate" working capital with no figure or formula.
- Reducing working capital before closing in the belief that the cash is the seller's to take. The peg adjustment returns it to the buyer.
- Overlooking liabilities such as customer deposits, gift cards and warranty obligations, which buyers treat as debts they are assuming.
- Using accounting methods at closing that differ from those used to set the peg.
Preparing as a seller
An owner can take three steps before going to market. Produce monthly balance sheets for the past two years, so the working capital history is available. Clean up receivables, inventory and accruals, so the figures are reliable. And decide, with an advisor, which convention fits the business and what peg the history supports.
Working capital is a technical subject, but the principle is simple. The buyer and seller must agree on what is being delivered along with the business, and they must agree on it early.
Twelve31 Advisors analyzes working capital history as part of valuation and addresses the treatment explicitly in every letter of intent.
