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  • Lee Henry

Working Capital Explained

You’re selling your business, and everything is in order. You've hired an investment bank, they've prepared an investment memorandum, solicited bids, and found a buyer willing to pay a substantial amount for the hard work and dedication you’ve poured into the business over the years. You've successfully passed the due diligence phase and are now negotiating the final details of the purchase agreement. The finish line is in sight, but now you encounter the working capital peg.

The working capital target, also known as a “peg” or “true-up,” is a crucial part of an acquisition where millions of dollars are at stake. It's often misunderstood and typically addressed in the later stages of the deal. Many sellers leave significant money on the table, benefiting the buyer, due to a lack of understanding and early attention to the working capital issue. Sellers should ideally understand the impact of working capital well before starting the sale process. Below, I explain how working capital can significantly impact the cash you take home after selling your business.


What is Working Capital?


This isn’t a trick question. Generally, we know what working capital is: it's a measure of operating liquidity available to a business at a given time, calculated as current assets minus current liabilities. Practically, this usually involves four main balance sheet accounts: cash, accounts receivable (A/R), inventory (INV), and accounts payable (A/P). I'll delve into these accounts further and touch on other potential areas as well.

Working capital is essential for the day-to-day operations of a business. It's as crucial as employees and physical assets. While some businesses operate on negative working capital, like subscription-based media companies requiring large upfront payments from customers, most firms need positive working capital that grows with the business.

Most acquisitions are structured as cash-free, debt-free stock or asset acquisitions. This means the buyer acquires a business with no financial debt and limited or no cash in the operating account. Buyers often require minimal cash to remain in the business to meet short-term needs without drawing on an interest-bearing revolving facility or delaying vendor payments or payroll. Net working capital (NWC) is working capital minus excess cash.


Why Does Working Capital Matter?


From a buyer's perspective, working capital has two key implications: one related to the acquisition purchase price and the other to the ongoing cash flows of the business.


Cash Flow Implications


Working capital is a real investment in the business, much like essential machinery or computer hardware, and cannot be fully liquidated without negatively impacting the business. Working capital accounts tend to grow with the company’s revenues.

For instance, if in year 1, I generated $1,000 in revenue and $200 in EBITDA, and had $300 in A/R, $300 in INV, and $200 in A/P, the NWC would be $400. That’s $400 in NWC needed for the business to run smoothly. In year 2, if revenues and EBITDA double to $2000 and $400 respectively, NWC should also double to $800, assuming constant payment terms and inventory levels proportional to revenue. Therefore, while revenues and profits have grown, the NWC impact must be considered to understand the cash flow result. The initial $400 EBITDA in year 2 required an additional $400 in NWC investment.

Understanding working capital's impact on cash flows is crucial for business owners. By tracking collections, payments, and inventory levels monthly, business owners can minimize the money tied up in working capital and achieve higher prices for their businesses. Sophisticated buyers consider NWC needs in their models and will pay more for businesses requiring less NWC.


Purchase Price Implications


In most cases, net working capital remains with the business in an acquisition and is acquired by the buyer. The purchase price is determined early in the negotiation, but closing usually occurs months later. Working capital levels fluctuate for various business reasons, like seasonality, customer demand changes, payment term changes, new product lines, and geographic expansion. The buyer needs to ensure sufficient working capital at closing to run the business and avoid additional investments due to irregular seller activity before closing.

Working capital levels can change for legitimate business reasons or through seller manipulation. The working capital mechanism aims to ensure the business has the appropriate working capital level based on its average needs throughout the year and prevent the seller from manipulating accounts to drain NWC assets.


Key Working Capital Accounts

Cash


Cash is usually excluded from the sale, with the seller taking all cash from the bank account before or at closing. Sometimes, the buyer may request some operating cash to be left for day-to-day needs. Cash is controlled by the seller until closing and relates to pre-closing activities, typically excluding it from the purchase and working capital mechanism.


Accounts Receivable


A/R represents outstanding customer invoices and typically fluctuates with revenues, assuming static average payment terms. A seller may pursue outstanding A/R more aggressively or offer discounts for quick payment to increase cash proceeds before closing.


Inventory


Businesses usually maintain equilibrium inventory levels to provide satisfactory service. Sellers might stop replenishing inventory before closing to minimize cash investment and maximize cash proceeds.


Accounts Payable


A/P increases with business activity. Sellers could stop paying creditors or delay payments, risking supplier relationships and being cut off from key suppliers to maximize cash.


Other Accounts


Other accounts, such as prepaid expenses, deposits, accrued expenses, and taxes, are included in the working capital calculation but usually have less impact on negotiations.


The Working Capital Peg


To prevent sellers from manipulating working capital accounts before closing, buyers set a working capital target, or peg, based on historical levels. Shortly after closing, a third party assembles a closing balance sheet to calculate the actual net working capital delivered at closing. If the actual NWC exceeds the target, the seller receives the difference in cash. If there's a deficit, the seller owes the buyer the difference, known as the post-closing “true-up.”

The goal is to determine the appropriate working capital level for the business. The historical monthly balance sheets are used to set the peg, as they provide the most reliable information.


Setting the Peg


Various methods can set the peg, with the most common being a 12-month historical average. This average considers seasonality and abnormal months, providing a fair view of the NWC needed to run the business.


Special Cases

  • High Growth Businesses: Rapidly growing businesses may require a 12-month weighted average or an average based on the latest 6 or 3 months to accurately reflect NWC needs.

  • Negative Working Capital Businesses: For businesses with negative NWC, such as publishing or media companies, the target may be set at zero, with a true-up payment from the buyer to the seller post-closing.


Reaching a Fair Solution

The seller has the most leverage before the LOI stage when there are multiple bidders. Reaching an agreement on the NWC mechanism early can avoid conflicts and value loss later. Sellers and advisers should analyze historical monthly balance sheets, calculate rolling multi-month averages, and forecast major balance sheet accounts to understand NWC trends and potential true-ups at closing. This preparation can help avoid surprises and maximize operational efficiency through closing.

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