An ongoing question in the buy-sell industry is, “What’s included in the deal?” Especially when it comes to working capital. If you just peg a number, say whatever working capital was December 31 or June 30, either buyer or seller could be shortchanged because of seasonality or similar. So a formula that’s fair to both is what’s needed.
Let’s look at this with the understanding that, for this discussion, there are two types of businesses.
- A business that is really a job for the owner and the job is doing, making or selling the company’s product or service. These are small businesses, usually selling for under $1 million.
- A company where the owner’s job is CEO or president and he or she spends most of their time working on strategy, leadership, management and adding value to the sales process (not making all the sales calls). It usually takes a company selling for at least $2-3 million to allow this.
When selling the company in example one, the seller probably needs every last dime out of the deal. In example two, the buyer is truly buying an ongoing operation and expects there to be working capital included. There will be bills to pay the first week and that means money in the bank or accounts receivable against which the buyer can borrow.
Sometimes agreeing on how to calculate the amount of working capital gets laborious and even stressful. So I was glad to get the following overview from attorney Walt Maas at Karr Tuttle, which he sent to one of our mutual clients (and which he has given me the approval to use and share).
Customary for transactions to be cash free/debt free with a working capital adjuster that uses average Trailing Twelve Months (TTM) end working capital (generally A/R plus inventory, less A/P and accrued liabilities, but excluding in each case cash and current portion of any debt) as a target or PEG amount.
Closing date actual working capital, as so calculated, is then compared to the target working capital and the seller is paid the delta if closing working capital is higher than the target (theory is that seller has invested incremental cash to the extent of the excess and should be repaid that amount by buyer) or buyer is given a price reduction if closing working capital is less than the target (theory is that seller has liquidated working capital below the average and, as seller retains cash, should repay the delta to buyer by way of a price reduction). The idea is that the TTM average, with the adjustments described above, is the amount of working capital at closing necessary to run the business.
Using a working capital adjuster also polices the management of working capital by seller prior to closing (i.e. no benefit to the seller of accelerating A/R or delaying payment of A/P as a means of generating retained cash) and provides a back stop to the buyer’s working capital diligence by means of a post closing true up process to determine actual working capital at closing.
Yes, the above gets modified based on circumstances but it’s a fantastic starting point (thanks Walt!). His definition covers (most of) what’s needed, is an average not just “the closing balance” and prevents either side from feeling manipulated by circumstances.
When it’s fair for both sides it makes the deal a lot easier.
