How Much Working Capital Conveys in an M&A Transaction?
Different types of businesses require different amounts of working capital. For companies that require a lot of working capital, the exact amount of working capital to convey to in an M&A transaction can be a significant negotiation point. Below, I discuss working capital and how it typically conveys in an M&A transaction.
Working capital is defined as current (short-term) assets minus current liabilities. For most companies, the majority of working capital is tied to the difference between accounts receivable (AR) and accounts payable (AP). AR is what is owed the company but hasn’t yet been paid. AP is what the company owes but has yet to pay. Collecting AR generates cash (inflow). Paying down AP consumes cash (outflow).
Conveying Working Capital
The amount of working capital to convey is important because the more working capital that conveys with a transaction, the more value is transferred from the seller to the buyer.
Businesses need working capital to operate. To this end, working capital is a production asset, like any other tool owned by the company that is used to produce cash flow. It’s just that the working capital remains in financial form, rather than in physical form on the shop floor. Fundamentally, this is why it conveys with the business… because it is required for the company to operate to produce the projected cash flow.
From a practical point of view, if the working capital does not convey, the buyer will need to infuse the company with new working capital (cash) to ensure the company can meet its short-term obligations. From the buyer’s perspective, this effectively increases the cash required to acquire the company.
Excess Working Capital & Valuation
Sometimes business owners carry working capital in excess of what is required to operate the business. Perhaps they are financially conservative and choose to carry considerably more cash than required. Perhaps they fundamentally do not like to owe money and thus, pay their vendors quickly, thereby reducing the accounts payables. There are a variety of reasons why working capital might be in excess of what is required to run a company.
For valuation purposes, you simply add the amount of excess working capital to the valuation of the business as if it were cash.
For example, if a company is valued at $30 million and needs $1 million in working capital to operate, that $1 million will be expected to convey with the sale of the business to the buyer. However, if the company actually has $4 million in working capital, the $3 million excess working capital will either: a) not convey and will (eventually) be distributed to the seller or b) convey with the company and the purchase price will be adjusted dollar-for-dollar for the excess amount. In this example, the valuation to the seller is therefore $33 million.
Peg and True-Up
The amount of working capital to convey with a business in an M&A transaction is often mentioned in the Letter of Intent (LOI), but certainly agreed upon in the purchase agreement (contract). Although it makes sense to try to peg the working capital to the actual working capital required to operate the business, getting the value exactly correct is less important than defining the amount of working capital that is expected to convey. Once pegged, simply think of this as a number included in the purchase price.
Due to the delays and timing of financial transactions, on the day of closing, it can be quite difficult to know with certainty the exact amount of working capital actually conveying. For this reason, to be fair to both buyer and seller, purchase agreements normally stipulate a date for a “true-up” of working capital, also known as a “working capital adjustment”.
3 to 6 months after the closing date, the accounting dust has will have settled and the actual amount of working capital conveyed on the day of closing is calculated in retrospect. If the amount conveyed was greater than the pegged amount stipulated in the contract, the buyer remits the difference back to the seller. If the working capital conveyed was less than the pegged value, then the seller remits the difference to the buyer.
In this way, the actual value of the working capital to convey does not need to be known with certainty on the day of closing, nor do the parties need to get it exactly right in the purchase agreement (although it should be close). Ultimately, it’s recalculated a few months after closing and adjusted to ensure both buyer and seller received a fair settlement.