By John Klearman, Principal
San Diego Office, Corporate Finance Associates
Many business owners don’t give much thought to the fluctuations in their equity and working capital, but as they relate to selling a business, they should. Either item can have a material impact on a seller’s ultimate windfall at closing.
An Equity Target is an amount of equity (assets less liabilities) delivered to a buyer when a business is sold. In Mergers and Acquisitions (M&A) buyers typically argue that the equity target is the amount of equity required to operate a business under normal conditions and it may include any asset or liability category. A Working Capital Target is more narrowly defined as the amount of excess current assets over current liabilities, established as a target that buyers may require at the time of sale. Once again, the buyer’s argument is that the level of working capital proposed is necessary to run the business under normal conditions.
Consider an example of how a buyer proposes an equity target for a business they want to purchase. Buyer A presents a letter of intent (LOI) to Seller B for $10 million to acquire the assets of a business. The LOI stipulates that the seller deliver $1 million in equity on the closing date. The LOI further stipulates that if there is an equity shortfall upon closing, the seller must make up the difference by adjusting the purchase price of the business. To protect themselves, the buyer’s LOI calls for $500,000 to be held back at closing and in the event of a shortfall, the buyer will simply pay less for the business.
Working Capital and Equity Target Risk
In order to assess risk associated with these targets, each asset and liability must be examined to determine its “degree of potential variability” between the signing of a letter of intent and the close of a sale.
Current Assets and Current Liabilities Have the Highest Degree of Potential Variability Between Signing a Letter of Intent (LOI) and Closing the Sale of a Business.
Inventory changes quickly. Accounts payables change quickly. Cash levels may fluctuate dramatically. Payroll liabilities can be substantially different depending on which day in the payroll cycle the equity or working capital target amount is being calculated. Seasonal adjustments to staffing may present substantial differences between the time a LOI is signed and a deal gets completed. Moreover, tax computations in stock sales (versus asset sales) can dramatically impact equity or working capital to be delivered.
So, working capital targets directly introduce risk into a deal and equity target calculations have the potential to create significant risk. In athletic parlance, current assets and current liabilities are our fast sugar. They go in fast and burn off quickly.
A properly computed equity target or working capital target is critical…it minimizes changes between what buyers and sellers originally agree to and what is ultimately computed on the closing date. In most cases, one or both parties will be required to alter their original expectations of how much equity should be delivered to run the business. If the original expectation is substantially different from the end result, buyers or sellers may reconsider their fundamental positions regarding the whole transaction. One of the two parties is typically required to fund that difference. Even a few percentage points of difference can create early stress in a newly forming relationship.
Mitigate Working Capital and Equity Target Risk
The seller must diligently confirm that the buyer’s request is appropriate and reasonable. All deals are different and there are no rules. The seller may choose to negotiate on any of the elements of a proposal by the buyer. Assuming the buyer insists on the delivery of equity for its offer, how can the seller reduce the variance risk between the time the LOI is offered and the time the transaction closes?
1) Historical Analysis — Compare each account deriving the equity or working capital target to its historical levels at times that “behave” similarly to the actual closing date. If a closing is to occur in December, then review historical months that are similar to December. If sales have substantially increased, then perform a ratio comparison of the historical accounts to actual sales. Make adjustments for the projected period accordingly.
2) Focus on Highest Risk Accounts — We know that fluctuations occur in current assets and current liabilities. Concentrate on those that seem to vary the most. For instance, if you’ve had differences in your historical inventory counts to what was booked as inventory, and you’ve had to make ongoing adjustments, you have risk associated with the proposed equity or working capital target.
3) Protect Yourself in the Purchase Agreement — You will notice in the previous example the buyer is holding back $500,000. I also noted that in the event of a shortfall the seller essentially is required to make up the difference. Well, what if there is a surplus? Your investment banker and attorney must negotiate to ensure you benefit if a surplus does occur. Moreover, ensure the computation of equity delivered is spelled out completely in the purchase agreement. Usually Generally Accepted Accounting Principles (GAAP) will be the standard by which the computation occurs.
Working capital targets and equity target provisions are significant issues to manage in the sale of your company. Make sure you seek the guidance of your CFA professional as you work to maximize your return and mitigate your risk.
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