Today, most buyers will include language around working capital in the Letter of Intent (“LOI”), usually in the framework of a working capital target. Many sellers are unaware or confused by this complicated concept and strike a deal on a purchase price expecting that they will take home the millions of dollars that they have in receivables – only to find out later that is not consistent with the terms they agreed to in the LOI. I’ve heard this line a million times; “I did the work; the receivables should be mine.” Unfortunately, that’s just not how it works. This realization can be quite frustrating to sellers as it means the proceeds they were expecting in their mind will in fact be lower, sometimes materially lower. This can be particularly frustrating after months of hard work during diligence, when the thought of starting over with another buyer makes your head spin.
What’s wrong with thinking that those receivables belong to you because you did the work? While that is a sensible argument and there’s nothing inherently wrong with it, that is just not how the M&A market handles this. Sellers must remember that buyers base their valuations of the target business using a multiple of TTM cash flow. Many times this will be reflected as a multiple of EBITDA, but keep in mind that EBITDA is at its heart is a proxy for cash flow. If your business generated $2 million of EBITDA and a buyer paid a multiple of 6.0x, the buyer would be expecting to generate a minimum of $2 million of cash flow in the first year in order to pay its debt, fund growth expenditures, and generate a return for itself. Instead, if the $1 million of receivables you had on the books didn’t transfer to the buyer, the first $1 million of cash the buyer generated would go straight to rebuilding the balance sheet. The buyer would not be able to meet its requirements and objectives. If you wanted to go that route, a smart buyer would reduce the purchase price in order to offset the lost cash flow.
While folks have different ways of thinking about this, there are two real world examples that I think are the easiest to grasp.
The first example is a rental car. The working capital of your business is like the gas in the car – you need the fuel in the car so you can drive the car off the lot. You need to return the car with enough fuel so that the next renter can do the same. That example is fine, but I think there’s a better one.
When you buy a car off the car lot, you expect to pay a price based loosely off the MSRP. The MSRP is the suggested retail price that the maker believes is the market clearing price for a car with those features. When you show up to the Toyota dealership to buy the Camry because your online research indicates that the Camry is a better deal than the Accord, you would be upset to find out that after you sign on the dotted line, now you have to spend thousands more for an engine and a fourth tire, both of which the Accord included in its sticker price. It works similarly in the M&A world. Buyers that are paying a market clearing price for your company are expecting the working capital to be included in the deal just as you are expecting your new car purchase comes with an engine and four tires.
So we know how buyers will view working capital in the context of an M&A purchase, but how will the mechanisms function at close? My neighbor who sold his business recently mentioned a “working capital target.” What does a working capital target mean?
As mentioned earlier, buyers will often insert language in an LOI that states something to the effect that the
seller will deliver the business at close with a normalized level of working capital. What does a normalized
level of working capital mean? In broad strokes, it means that the business has enough in terms of receivables that it will receive from customers in the near-term in order to make payroll and otherwise function without the buyer having to stroke another check into the company. How this normalized working capital is determined is usually based on the average of a historical lookback period, ranging from the prior three months to the prior twelve months. Very often, the lookback period is twelve months. This average is referred to the working capital target.
Shortly before closing, the seller will prepare an estimated balance sheet as of the day of close and will share this balance sheet with the buyer. The working capital shown on this estimated balance sheet is then compared against the agreed upon target. If the working capital delivered at close is higher than the target, the seller is delivering more assets than necessary and the buyer will increase the purchase price to reflect the surplus. If the working capital delivered at close is lower than the target, the seller is delivering fewer assets than expected and the buyer will be compensated for the deficit through a purchase price reduction.
Since this is based on an estimated balance sheet at close, there is usually a true-up mechanism completed 60 days to 90 days after closing, once both sides’ accountants have been able to agree to an actual figure.
While sellers may still view this as “unfair” it is the nature of the beast and commonplace in the M&A industry. As is the case in all things M&A, it is better to fully understand what you are signing in the LOI than to be disappointed later on. For those lucky sellers with multiple offers, it also helps in order to be able compare those offers on an apples-to-apples basis. Make sure that your broker or investment banker understands how buyers view working capital and can negotiate the target in your favor. You might be surprised how often they don’t understand this concept.
It’s a challenging market for someone who hasn’t dealt with it before. I am more than happy to help.
Sincerely,
Sincerely,
Graham Gilbert
M&A Done to a Standard
813-668-7855
Disclaimer: This article is for general information purposes and is not intended to be and should not be taken as financial or legal advice. G2 Capital Advisors, LLC is not responsible or liable for any actions taken or not taken as a result of this article. G2 Capital Advisors, LLC assumes no responsibility or liability for any errors or omissions in the content of this article. The information contained herein is provided on an “as is” basis with no guarantees of completeness, accuracy, usefulness or timeliness.
