Middle Market M&A: Some Thoughts on Working Capital

December 04, 2015

The purpose of this brief note is to share a few observations about how net working capital is handled (or mishandled) in middle market M&A transactions. As will be seen, there is far more at stake than most sellers, buyers and advisors may at first think.

Most accountants and financial types will be nodding their heads in affirmation of the need to address this topic early in a sale process. Investment bankers certainly know to tee up the issue early and often. For lawyers, net working capital will often seem to be about prorations-like closing adjustments and post-closing reconciliations against estimates, which wrongfully relegates the topic to a mechanical accounting exercise. It is anything but that.

When a client states that he is selling his company and a price has been agreed, one of the first questions should be how much of the net working capital is included in that price? When a sale occurs without an investment banker, this point is often overlooked and there is often a material disconnect on pricing. The seller probably expects to take cash out of the company, but does not necessarily think about whether the agreed price covers all of the other elements of net working capital that can quickly enough turn into cash. The buyer may or may not expect to get the cash for the price, but may expect all or some of the remaining net working capital as part of the purchased assets.

One of our acquiring clients always made this relatively easy by setting a price for a target company that covered the target’s machinery, equipment and good will, and then he would pay dollar-for-dollar for the net working capital. We refer to this as “Frank’s method.” There was never any ambiguity about the value proposition in Frank’s deals.

In a recent deal for another client, the letter of intent was silent on net working capital. Without language on point, the buyer was entitled to all of the net working capital for the agreed price. This could have been the deal, but in most cases it is not. Given the significant periodic swings in the net working capital of the typical middle market company, it is hard to imagine many deals in which the parties intend that the same price will cover net working capital at its historical high or historical low. In many middle market companies ownership may (for convenience) leave sizable amounts of cash in the company, not needed for the efficient operation of the seller. Would this excess cash, or unusually high levels of receivables (that will turn into cash) or inventory that turns into receivables that turn into cash just “come with” the company? Probably not.

For buyers, a negotiated price will often include a “normalized” level of working capital based on historical averages of what it required to run the company efficiently. Thus the critical elements are:

1. Identifying the amount or range of net working capital that is included in the price.

2. Estimating the net working capital at closing for an adjustment to price (e.g., if the net working capital exceeds the target, the price goes up dollar for dollar for the excess, and vice-versa for shortfalls).

3. Performing a post-closing true up of the actual closing date net working capital against closing date estimates.

Easy enough it seems, but there are plenty of complex and nuanced issues. One of the issues we come across relates to comparability of methods of calculating working capital components such as inventory and accruals. For any given type of expense, there may be more than one way to accrue for it. Clients may accrue in accordance with GAAP, or not. The method of accounting for inventory costs is often complex and, as many accountants know, clients do not always get it right.

When determining whether a working capital target is met, or the over-under, should the parties use the same method of costing inventory or accruing that the seller has used (for comparability purposes), or should the true-up be based on a “technically correct” GAAP method even if it differs from what the seller used in the financial statements on which the buyer based its pricing?

The answer may not be obvious. There is something to be said for comparability: if the seller agrees to deliver $1 million of net working capital calculated (so far as the seller is concerned) in the way the seller has always done, should that not be the measure of the value he is required to deliver? But is it fair to say that the buyer should have understood this in the peculiar way that the seller may have calculated its working capital? Probably not.

One can make compelling arguments in support of both the subjective and objective views. The point is to give the matter of net working capital quality thought, early in the process, involving the parties to the transaction, the investment bankers, the accountants and the lawyers. This is a challenge because it seems to be putting the cart before the horse (i.e., putting technical accounting issues ahead of the pace of the deal). The response to that, however, is that net working capital is all about price, and if it is not too soon for a buyer to say he will pay $X for the business, it is not too soon to know what the buyer does (or does not) get for the price.

Everything begins with the right people.

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