In the accounting world, Working Capital (WC) is often defined simply as Current Assets less Current Liabilities, reflecting the liquidity level to run day-to-day operations of the business.
However, whilst the accounting definition can be simple, the effect of WC upon negotiations during a M&A transaction can be significant.
Through the deals we have worked on, Chessboard has seen WC become an increasingly important focus of discussion, with the definition of WC and its calculation being more heavily negotiated. The below article seeks to provide a brief explanation of Working Capital, what are its constituents, and the potential questions which may arise during a transaction.
What is Working Capital?
Working Capital reflects the funds or liquidity required to run the operations of a business on a day-to-day basis. The term Net Working Capital (NWC) is often used to reflect this figure, as the net of all the asset components and liability components of WC. As a starting point, this would generally include a business’ Trade Debtors, Inventory and Trade Creditors.
If NWC is positive, then the business is self-sustaining and does not require any outside capital. If NWC is negative, the business may require additional capital to support its operations.
Tackling Working Capital for a M&A Transaction
When a business is acquired as a going concern, the buyer would typically require a certain level of NWC to be left in the business at completion. The Target NWC is typically the “maintainable level of working capital” a business requires to operate. This NWC is such that the business can continue in its same state without the buyer needing to inject additional funds to maintain the operations of the business on Day-1.
Imagine if you had just acquired a business and in the first week of ownership you had to immediately order stock because no stock was left in the business. This would be the situation without the vendor leaving sufficient WC in the business at completion.
Target NWC
A Target NWC (or ‘peg’) is often agreed during due diligence. This is the minimum amount of NWC required to maintain the operations of the business. At completion, the actual level of NWC present is compared to this agreed Target NWC.
The buyer pays more for the business if Actual NWC is more than the Target NWC; the purchase price is reduced if Actual NWC is less than the Target NWC.
- Working capital adjustment = Working capital position @ settlement – Target working capital
It is noted, the purchase price is not adjusted for the full amount of NWC – only the difference between the Target NWC and amount present at completion.
Challenges of Calculating NWC
The vendor and acquiring party typically agree upon the Target NWC during due diligence. Given the potential for adjustments at completion, an acquirer wants to set the target as high as possible and the vendor as low as possible.
Determining a reasonable NWC target can become a separate negotiation as this tension may lead to difference between what each party sees as the “maintainable level of working capital”. Some examples of different topics which may arise when negotiating a Target NWC include:
1. Period to Average
In determining the Target NWC, it is common for parties to agree to use the average amount of NWC as the Target. However, over how long of a time period should this target be set?
- 90 days so most recent?
- 180 days so at least a half-year?
- 365 days so have one year average?
In growing (or shrinking business) the effect of the date-range chosen can be even more profound, with averages changing dramatically as the time-periods are moved.
2. Negative NWC
Some business operate with a negative NWC position. This includes industries like retail stores where customers pay cash upfront, but inventory is often bought on terms with potential long creditor days.
In our experience, most business acquisitions are made on a “cash-free and debt-free basis”. That is any cash in the business at completion belongs to the vendor.
If average NWC is negative, how should the target be agreed? Should cash be held back in the business to cover the future creditor payments required?
3. Seasonality & Industry Factors
Some businesses can be particularly seasonal in their working capital requirements. For example, retail stores which generally need to “stock up” in the lead up to the Christmas season, but then reduce stock levels early in the new year.
Basing a Target NWC on an average level may benefit the buyer or the vendor depending upon what time of year completion ultimately occurs. In the example above, Completion NWC may be lower than the target if in the New Year, or higher than the target if just before Christmas.
4. Non-recoverable debtors or inventory
When setting the Target NWC and calculating the NWC position at completion, a great deal of negotiation often goes into what should be included or excluded from the calculations.
Whilst debtors and stock should be an easy item to agree on, the devil is in the details. Many organisations often carry a level of debtors which likely won’t be collected, and out-of-date or obsolete stock which either likely won’t be sold or would need heavy discounting.
A simple solution is to set a date limit for when such items would be included in the calculation. However, this should also be considered when setting the Target NWC as well – how many of the historical reports had these items in the numbers?
5. Exceptions
As mentioned at the beginning of this article, an easy definition of WC is Current Assets less Current Liabilities. However, when it comes to M&A transactions, there is no hard and fast rule about what is included and excluded as part of WC. There are often items which are negotiated out of the calculation.
Some examples of common exceptions we see are:
- Cash & the current portion of interest-bearing debt – many M&A transactions are made on a “Cash-free & debt-free basis” with these items excluded from the purchase price
- Employee entitlements such as annual leave – often employee entitlements are adjusted for separately in an M&A transaction [sometimes in full, or the ‘excess’ portion – a future article will dive into this]
- Non-operating assets or liabilities – balance sheet items which aren’t related to the running of the business, for example shareholder loans
- Accrued Income Tax – often treated as a debt item, reflecting its relationship to prior-period profits
All of the above factors should be carefully considered during deal structuring to ensure the appropriate Target NWC is agreed and a successful outcome is achieved for all parties.
Reach out to the Chessboard Group team at info@chessboard.group