The working capital target concept is fairly common in M&A transactions. In fact, we have experienced this concept in nearly every transaction that we have participated in over the years. That said, no one — neither the buyer nor the seller — really likes to deal with the working capital negotiation. As a matter of course, however, the working capital negotiation is a necessary evil.
What is working capital? In accounting terms, working capital is the capital of a business that funds day-to-day operations. It is literally calculated as current assets minus current liabilities. In a transaction, working capital typically excludes cash (and cash equivalents) and funded debt (both assuming a “cash-free, debt-free” transaction), unless the buyer and seller have negotiated a different understanding regarding cash and debt. Certain other current assets such as related party notes receivable and other current liabilities such as income taxes or accrued transaction expenses will also likely be excluded from the working capital definition. Ultimately, the buyer and seller will carefully negotiate exactly what is included in the working capital definition.
By definition, the working capital target concept means that the seller is required to deliver to the buyer at closing that specified level of working capital to support the company’s operations post-closing. It is negotiated based on a variety of factors, and is traditionally thought of as an adjustment to the purchase price. A target that is too high reflects a reduction in the purchase price, whereas a target that is too low essentially increases the purchase price.
In addition and as noted in our last post, the working capital concept is included in most transactions to assure the buyer that the company is being operated in the ordinary course for the duration of the transaction through to the closing. That is because working capital reflects the ongoing business activities of a company, which in general should not be disrupted or materially altered during the course of a sale process. If the working capital is depleted prior to closing (intentionally or otherwise), then there is a real cost to the buyer to replenish working capital to an appropriate level. If the seller delivers working capital in excess of the target, then the seller has delivered more value to the buyer and is paid for that additional value.
The working capital concept is typically specified in the letter of intent (“LOI”); however, the specific working capital target is not negotiated until much later in the transaction, often after the buyer has completed the quality of earnings (“QoE”) review, which includes a working capital analysis. As the deal and due diligence progress, there are two primary elements in the negotiations between the buyer and seller: i) agreeing to the formula to calculate working capital and ii) agreeing to the working capital target based on that formula. For example, a deal may stipulate that the seller will deliver $10 million of working capital at closing based on the agreed-upon formula.
It is important to carefully define in the purchase agreement exactly how working capital is calculated and include examples. This is sometimes defined to be the “working capital methodology.” The purchase agreement should also be clear that the closing working capital will be calculated using the same formula that was used to determine the working capital target. If not, buyers can play games with the determination of the closing working capital. For example, many private companies do not maintain a bad debt reserve. They write-off accounts receivable on a realized basis. However, it would be in accordance with GAAP for the closing working capital to include a reserve for bad debts. If the closing working capital includes a reserve for bad debts and the calculation of the working capital target did not include a reserve for bad debts, this would reduce closing working capital and lead to a price adjustment that would be in the buyer’s favor. For just this reason, the buyer and seller must agree on the working capital methodology, which states how the target was calculated and in turn how the closing working capital will be calculated.
Once the parties agree on the working capital formula, the working capital target is generally determined by calculating the company’s average monthly working capital (based on the formula) over a pre-defined period of time, usually the previous 3, 6, or 12 months. However, the process to determine the working capital target varies depending on the business or industry in which the company operates. If a company operates in a seasonal or cyclical business, for example, it can be challenging to set a target because the company’s working capital can vary significantly from month-to-month or quarter-to-quarter.
As we wrote in our last post (linked above), neither the buyer nor the seller should make money once the working capital target has been set. In other words, if the closing working capital is lower than the target, then the seller has generated the cash to pay the buyer. If on the other hand, the closing working capital is higher than the target, that means the seller has delivered more assets to the buyer, and the buyer owes the seller the difference. At the end of the day, once the target has been negotiated, working capital should be neutral to both the buyer and seller.
After the transaction closes, the buyer will calculate the closing working capital and compare it to the working capital target to determine if the buyer owes money to the seller or vice versa, i.e., the “true-up process.” The true-up adjustment is typically made on a dollar-for-dollar basis. In the example above, if the working capital target is set at $10 million and the seller delivers $8.5 million of working capital, the seller would owe the buyer $1.5 million. Sometimes the buyer and seller will agree to a working capital “collar.” In other words, neither party owes the other party any money until the adjustment exceeds a certain amount, say 1% of the target.
In cases where the seller does not agree with the buyer’s true-up calculation, additional negotiations may be needed. If an agreement cannot be reached, the parties may need to invoke the dispute resolution process set forth in the purchase agreement.
The working capital target concept is a complex, but necessary, component of selling one’s company. Executed correctly, it can result in a fair and equitable conclusion to a sale. However, the working capital concept is a difficult point of negotiation for both the buyer and seller. As such, it can be useful for the seller to have the support of an experienced M&A advisor who can harness the benefits of the working capital concept and seek to optimize any potential value shifts that may occur as a result.
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