The amount of working capital in an acquisition target has a direct impact on the ultimate purchase price. Understanding its role — from initial due diligence through negotiations to the post-closing “true-up” — early on can help both the buyer and the seller achieve a successful transaction without post-dispute litigation or distraction.

Working Capital Basics

Working capital (or net working capital) is an indicator of a company’s financial health, as reflected by its ability to meet its short-term obligations and fund daily operations. High working capital levels, if properly managed, suggest that a company is well positioned to continue running, as well as to grow.

For financial statement purposes, working capital generally is defined as current assets (for example, cash, inventory, accounts receivable, and prepaid expenses) less current liabilities (for example, accounts payable and accrued expenses). In the mergers and acquisition context, however, the definition of working capital is slightly different.

Most middle-market deals are cash-free/debt-free — meaning the seller will keep the cash on the balance sheet and pay off the debts — with “normalized working capital.” Cash, debt, and debt-like items are excluded from the working capital calculation, therefore, and instead accounted for by purchase price adjustments.

The cash conversion cycle (CCC) is a useful measure of how well a company manages its working capital. The CCC is the length of time required for the company to convert its investment in inventory into cash. It incorporates three working capital turnover metrics:

• Days inventory outstanding (DIO): The average number of days the company needs to sell its inventory.
• Days sales outstanding (DSO): The average number of days the company requires to collect its account receivable on sold inventory.
• Days payable outstanding (DPO): The average number of days the company takes to pay its bills to suppliers, vendors and lenders.

A company’s CCC is calculated as DIO plus DSO less DPO. A lower CCC is a sign of a quick inventory-to-cash process — in other words, that the company’s working capital is tied up in inventory and receivables for a shorter duration and the company boasts sound cash flow and liquidity.

The Working Capital Peg

Working capital is the result of a timing difference between the point that a company is paid for its work and the point that it pays its expense related to the work. By its very nature, then, working capital varies over time.

To account for fluctuations, the parties to a sales transaction generally establish a working capital peg, or target, in the quality of earnings report. The existence of a peg also prevents a seller from aggressively collecting receivables, selling off inventory or skipping payments prior to closing in order to increase the cash that goes into its pocket.

The peg represents a normalized level of working capital that the seller must deliver at closing. If the working capital delivered lands above or below the peg, the purchase price generally is adjusted after closing on a dollar-for-dollar basis.

The seller wants the peg to be set as low as possible. The buyer takes the opposite stance, preferring a high peg that ensures it will not need to inject additional cash post-closing to maintain normal operations, bearing in mind the CCC and other factors. Thus, much of the negotiations will revolve around determining the appropriate working capital peg.

One common methodology for setting the peg is to compute the average monthly amount of working capital over the trailing 12 months. This length of time generally smooths out seasonal effects, nonrecurring items and other distortions, but a shorter period can be employed if it produces a more accurate result.

The Treatment of Debt-Like Items

Agreeing on the methodology for establishing a working capital peg is not the end of the debate, though. The parties also must negotiate on how to calculate the average — that is, which items are and are not included. For example, the buyer and seller may spar over whether certain items are working capital or rather “debt-like items” that reduce the initial calculation of purchase price.

Debt-like items do not appear on the balance sheet as traditional interest-bearing debt but have characteristics similar to debt (such as extended payment terms) or relate to non-operating obligations — and they will in effect remain a liability for the buyer after closing. Examples may include:

• Deferred revenues;
• Customer deposits;
• Accrued bonuses, vacation, and 401(k) contributions; and
• Accrued interest.

The buyer may identify debt-like items in its letter of intent after initial due diligence, or they might not arise until later. Either way, the parties should be prepared to negotiate the proper classification of such items, as they will directly influence the purchase price.  

Think Ahead

A target company’s working capital will have a major effect on its purchase price and the sustainability of the business after a sale closes. Both sides to the transaction will benefit from obtaining a comprehensive and accurate working capital analysis early in the process and clearly defining working capital, debt, and the peg in the purchase agreement.

If  you would like more information, contact Luca Pescarini at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Transaction Advisory Services.