Working capital impact on purchase consideration in M&A

When preparing to sell your business as a private entity, you are more likely than not to come across the term “the purchase price is X amount on a fully diluted, cash-free and debt-free (CFDF) basis, subject to normalized levels of net debts and working capital” when the buyer places a non-binding offer. Majority of owners proceed with the deal without fully understanding what these terms mean. In reality, the entire mechanism of the actual proceeds a seller (the owners) would receive is highly dependent on the resulting adjustments that term demands.

To ensure founders are dully educated, so as to minimize the friction or discord during due diligence adjustments negotiation, this article hopes to explore the cash-free debt-free basis, working capital and their effect on actual proceeds which sellers (owners) receive post-diligence.

What does “cash-free debt-free basis” entail

When a buyer tenders a bid to acquire your business, they are normally expecting to acquire a fully and normal operating entity, independent of financial or leverage decisions. Meaning, they hope to acquire Intellectual properties (IPs), the legacy technology, software and systems, the relevant operating assets including a normal level of working capital that will enable the entity to continue smooth operations immediately you hand over; Not your cash, nor your debt (often known in combination as net debt.

Often, the price which is quoted in the Letter of Intent, Term sheet or non-binding offer as “Purchase Consideration” usually embodies the enterprise value; what the operating business is worth independent of who owns what in the business (financing). However, that doesn’t necessarily indicate that at close, the seller (owner) is wired the Purchase consideration. This is because:

• If the working capital is lower than the “Normal”, “Target, or “Pegged” level, the buyer deducts the shortfall from the purchase consideration as they are required to inject cash upon to continue normal operations. If higher than the target, the seller is reimbursed by increasing the purchase consideration by the shortfall.
• If the business owes any debt at close of transaction, assuming no other purchase price adjustments, then the buyer must pay the full purchase consideration less the debt amount to acquire 100% of the business. To illustrate this point, assume the buyer bids at $100,000 and the target owes $10,000 at close, with other adjustments being $0, then the seller either pays $100,000 ($90,000 to the owners + $10,000 to the creditors) and acquire the business debt free, or pays $90,000 only (to the owners) and assume a liability of $10,000. If the business pays off $10,000 during negotiations and diligence, the buyer must pay $100,000 for the operating business ($90,000 for initial equity value + $10,000 to reimburse the owners for delivering debt-free at close).

Why working capital is unique in M&A

Working capital is unique because there is no single “right level” of operating & working capital to be delivered upon close. Sellers typically negotiate for a low “normal” working capital so they could easily meet or surpass the target and be reimbursed, why buyers negotiate that higher working capital is required to run the business normally, to adjust price down.

So, what is working capital? Simply speaking, working capital is current assets less current liabilities. To help put working capital in perspective, owners need to understand that they operating on a timeline called “operating cycle”. A normal trading business for example would be extended credit, say for about 30 days on average by suppliers. To maintain steady sales growth, they need to produce 60 days’ worth of sales and extend credit that takes 50 days on average to collect. This simply means that cash (the production cost) is tied up for 110 days (60 days + 50 days) but financed for 30 days, resulting in 80 days’ worth of production costs being tied up.

Trade working capital vs working capital

Trade working capital is restricted to inventories, operating cash (for banks, payment processing and Fintechs companies), account receivables and account payables. Working capital requirement on the other hand may include prepaid expenses or accruals (such as rentals, salaries, etc.). It is important to factor other working capital items when assessing for full working capital impact.

Steps required in normalizing working capital

Steps required to normalize working capital during a transaction process includes:

• Agree on a target or normal level of working capital: Buyers and sellers would often have to agree on a “normal”, “target” or “pegged” level of working capital prior to due diligence. This can be achieved using the days method, seasonality assessment and other historical working capital assessments.
• Obtain reported working capital: Reported working capital can be measured by subtracting the current liabilities from current assets. Also, historical working capital can be analyzed using “days method” including Days of Inventory Outstanding (DIO), Days of Sales Outstanding (DSO) and Days of Payable Outstanding (DPO).
• Obtain adjusted working capital: From items included as reported working capital, it Is required to strip out non-operational, cash-like or debt-like items to arrive at adjusted working capital. These adjustments could include cash and cash equivalents (if considered as working capital by the sellers), accrued interests, warranty provisions, related-party transactions etc.
• Factor in seasonality (swing high – low): Assess working capital data for historical seasonality patterns. This is to ensure the normalized working capital captures to effects of the swings (high or low)
• Normalize working capital: To ensure a normal level of working capital is targeted, a Last Twelve Month (LTM) average is recommended. This would help in smoothing out the effects of seasonality swings and show the actual growth pattern of working capital requirements.
• Compare normal level (obtained from diligence) to actual level at close: Upon close, compare normalized working capital to actual level. If there is a shortfall (if actual < Target/Normal), the Purchase consideration shall be adjusted downwards and vice versa.

Tying it all together: The purchase price mechanics

After achieving a target level of working capital, the resulting adjustments to determine the net proceeds to sellers (owners) include:

• Purchase consideration as per non-binding agreement: This is the amount stated as purchase price in the term sheet or Letter of Intent. This value will be subject to assessment during due diligence by adjusting and normalizing EBITDA or Revenue as the case may be and validating the agreed transaction multiple (EV/EBITDA or EV/Revenue).
• Adjust for Net debt or debt-like items: After thorough investigation into any liabilities or exposures in addition to reported claims including litigation, tax exposures etc. the outstanding balance at close of transaction is netted against the available cash and subtracted from the purchase consideration. Since some cash & equivalents are not operating items, they are available for distribution to owners.
• Working capital adjustment: When actual WC > target WC, the difference is used to reimbursed (added to the purchase consideration) owners. This is because at close, owners are delivering a working capital level higher than normal operating level. On the other hand, when actual WC < target WC at close, the difference is netted off (subtracted from) purchase consideration and thus sellers (owners) are left with lesser cash than originally agreed.
• Proceeds: After all adjustments such as EBITDA, Debt & debt like items, working capital and so on have been adjusted, the residual is what is wired to sellers (owners) subject to the transaction structure (such as lock ups and other performance-based considerations).

Conclusion

Working capital is a very unique and distinct aspect of a business. They are investments required to run a business effectively. Working capital typically considers inventories or cash required to sustain sales for a period, receivables balances required to be maintained to experience growth in sales, payables credit extension, and other working capital items. Buyers and sellers often disagree on the optimal level of working capital required to sustain operation upon transaction close. Sellers (owners) need to be aware of the bearing which working capital adjustments, in combination with other adjustments, can have on the proceeds they receive for the sales of their business. As a result, it is advisable for sellers (owners) to acquire a minimum required level of understanding of working capital and purchase price mechanics and also consult the services of a trusted advisor when embarking on the transformational journey of M&A.