Tuesday, 7 May 2013

Working Capital is Always a Point of Negotiation in an M&A Transaction

The determination of the closing amount of working capital is always a point of negotiation in an M&A transaction.  Simply put; working capital is current assets minus current liabilities and is the liquid part of the balance sheet, where revenues are collected and suppliers are paid.  Working capital often includes a component of cash (or access to cash in the form of a bank operating line).  Working capital items requiring judgement include:
·         Collectability of accounts receivable; typically accounts receivable aged greater than 90 days are not recognized;
·         Level of inventory; it must be current, sale-able and of an appropriate size;
·         Any stretched account should be examined for its cause and the potential impact on the customer /supplier relationship.
So what is the right level of working capital on closing?  Buyers and sellers should seek to establish a “normal” level of working capital.  This normal amount may not be the “right” amount on the day of closing but is the average level of working capital throughout an agreed period of time.  A reasonable rule of thumb would be to assume the same time period that the valuation of the business is based on.
 The following business characteristics will affect the normal working capital amount:
·         Generally speaking, a fast growing company will need more working capital to fund receivable and inventory growth than a no-growth business;
·         if the business is seasonal (for example, heavily dependent on Christmas sales) then, around Christmas working capital will be high, initially with inventory and then after Christmas receivables;
·         if payables are required to be paid quicker than receivables are collected (like staffing companies that typically have to pay contractors every two weeks while  they get paid monthly) then working capital will need to be high;
·         if cash is collected quicker than it is paid (like an online referral business that collects cash, has no inventory and does not have to pay its suppliers for 30-60 days) then working capital can be low.
·         Private companies may not manage their working capital as efficiently as they can.  They may leave cash in the business for tax reasons.  This will inflate working capital, so it is important to determine the level required by the business.
To determine normal working capital, cash flows should be examined for cyclicality and fluctuations for a minimum of the last 12 months.  Sometime before closing, a target closing balance sheet should be prepared reflecting a normal level of working capital.  Excess cash is typically distributed before closing and the actual level of working capital is not finalized until some time after closing.  If it is higher than the normal level of working capital, the seller receives the excess or, if below the agreed upon amount, the buyer is due a credit.  In some cases reserves are held in escrow for the purpose of funding a potential working capital deficiency. 
As every business and every seller is different, working capital will always be a point of negotiation in an M&A transaction.  The working capital issue is more complex than one would think and the amount of capital that is required for working capital can affect the value of a business.  Once you fully understand the cash flows in a business you can settle on a reasonable level of working capital.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap M&A International in Toronto.