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Capital Ideas for Private Business

Potential Deal Killers: Working Capital and Working Capital Adjustments

By Jim Zipursky, Managing Director
Omaha Office, Corporate Finance Associates

MoneyThere are lots of different factors which can kill a deal, most of which can be easily avoided. One potential deal killer which can always be avoided is the Working Capital Adjustment (“WCA”).

What is a WCA? First, we need to define Working Capital. In its truest form, Working Capital is Current Assets minus Current Liabilities. In the M&A world, we also consider cash free/debt free Working Capital, which is (Current Assets minus Cash) minus (Current Liabilities minus Current Interest bearing debt instruments).

Why is Working Capital important to buyers? Think of the business as an engine and the Working Capital as the fuel to power the engine. Buyers want to know they have enough working capital to operate the business after an acquisition.

Enough is a relative…and…negotiable term, which is where the WCA comes into play. Sellers would like to include as low an amount of Working Capital in a transaction as possible while Buyers want as much as reasonably can be included. With a WCA, the final purchase/transaction price is adjusted by the difference between the target Working Capital and the final, closing Working Capital.

Defining the Target

While calculating Working Capital is quite straightforward, there are as many ways to define the Working Capital target as there are colors in the jumbo-size box of crayons. The Working Capital target is the amount of Working Capital a buyer expects to acquire with the business. Much to the frustration of buyers and sellers, determining the right “target” is more art than science. We have seen all of the following methods used/offered by acquirers as formulae to determine the Working Capital target:

  • Average cash/debt free Working Capital for the 12 months prior to Closing
  • Average cash/debt free Working Capital for the 24 months prior to Closing
  • Working Capital at the most recent year-end audit
  • Average annual Working Capital for the past 3 years
  • Average quarterly working capital for the past 4 quarters
  • Amount equal to 45 days’ worth of Cost of Goods Sold

While each of the formulae above will work, none are perfect and each is open to discussion, interpretation and negotiation. Furthermore, the above methods for calculating a proper Working Capital target do not take into account any of the following issues:

Seasonal businesses require special attention. Any Working Capital formula which includes averages is problematic for seasonal businesses because averages even out highs and lows. The problem with averages for seasonal businesses is they either penalize or reward the buyer or the seller depending upon the time of Closing. This Working Capital Table illustrates why averages don’t work with seasonal businesses.

With the data from the table above, assume a buyer proposes using average Working Capital from the last six months for the Working Capital target and subsequent WCA; further assume a Closing at the end of Month 6. At Closing, the Working Capital is $500,000 but the average for the past six months was $2,750,000. In this example, the purchase price would be reduced by $2,250,000. If the table were reversed (e.g., month 6 becomes month 1, etc), the purchase price would be increased by $3,250,000 ($6,000,000 Working Capital at Closing minus $2,750,000 average Working Capital). Timing is everything in the case of using averages for seasonal businesses.

Proper accruals for A/R and inventory also require proper attention. In our experience, most businesses which do not have reviewed or audited financial statements, rarely, if ever, properly accrue for uncollectible A/R and/or obsolete/slow-moving inventory. Even some businesses with reviewed statements do not properly account for their obsolete/slow inventory. Frequently, we also see the reverse problem: business owners who “play with” their inventory figures in an effort to reduce taxes.

We understand the reasoning behind owners’ reluctance to recognize uncollectible A/R and obsolete/slow inventory. However, by not properly accruing for or recognizing reduced levels of A/R and inventory, the business owner is unintentionally overstating his/her Working Capital. This will come back to haunt the owner when it is time to sell the business.

How can this impair the sale of the business? Virtually any and all buyers will require a physical inventory prior to or concurrent with Closing. Virtually all buyers will also review every A/R for aging and collectability. Buyers are unwilling to pay for obsolete/slow inventory and uncollectible A/R. However, if the business has not accounted for these items, Working Capital will be overstated, which will translate to a purchase price reduction when actual/proper A/R and inventory are accounted for at Closing.

What to Do: Steps Forward

First and foremost, if a business owner is considering selling the company, it is imperative the owner understand the company’s Working Capital needs and can properly determine how much Working Capital is truly necessary to operate the business efficiently and effectively. Even buyers of businesses should have a very good idea of the Working Capital needs of the company they seek to acquire.

Second, we always recommend our clients engage their CPA firm to provide them with audited financial statements. The price paid for the audit is inconsequential when compared to the potential ramifications of the WCA.

Third, sellers of businesses should be prepared to define their own target Working Capital before they enter into discussions with buyers. The target should be defined logically and backed by credible data and historic information.

Finally, in a perfect world, when it comes time for Closing, a well-constructed WCA will result in zero adjustment.

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