Working capital is a well-understood reality to business owners – it is the funds required to manage a company’s day-to-day operations. It reflects the balance of collections from customer payments and the disbursements made to suppliers. However, the calculation and treatment of working capital is often complex and heavily negotiated in a sale transaction. Buyers want to ensure the acquired business is able to continue meeting short-term operating requirements post-closing, as they would need to provide additional capital if a seller failed to do so. Sellers, on the other hand, want to be adequately compensated for business that they have already performed and are cautious about handing over more working capital than necessary at closing.
Acquisition agreements typically include working capital adjustments in order to protect against potential adverse shifts in value and ensure the new business has the appropriate level of working capital. These adjustments are particularly relevant for commodities businesses given that they hold significant inventory that is subject to price volatility and largely financed by short-term secured debt. A well-constructed working capital adjustment mechanism negotiated early in the process will protect both buyer and seller, prevent last-minute surprises and provide a greater level of certainty that the transaction will close.
Defining Working Capital
In accounting terms, working capital is simply defined as the difference between current assets and current liabilities. Balance sheet items typically included are cash, inventory, accounts receivable, short-term debt and accounts payable. These components represent items critical to a company’s daily operations and revenue generation. Because most transactions are completed on a “cash-free, debt-free” basis assuming a normal level of working capital, cash and short-term debt are excluded from working capital. Other items normally excluded may include loans to officers, intercompany accounts and shareholder receivables – reflecting items which are not part of the liquid assets and liabilities necessary to operate the business. While the working capital calculation appears straightforward, the traditional definition is often modified to account for specific characteristics of a business. In a transaction, it is critical that the buyer and seller reach an agreement on the specific current assets and liabilities to be included in the definition of working capital. The accounting principles used to define working capital should also be consistent with past accounting practices and industry norms.
Constructing a Working Capital Adjustment Mechanism
One complicated and unavoidable issue in a transaction is that the purchase price of a business is determined on the signing date, whereas the company continues to operate until being transferred to the new owner on the closing date. The period between signing and closing typically ranges from a few weeks to a couple of months, during which time the business’s working capital balance will inevitably change. Accordingly, best practice is to construct a mechanism to adjust the purchase price for changes in working capital between signing and closing.
As noted, the adjustment mechanism is particularly important for commodities firms because their balance sheets are primarily composed of inventory that is exposed to commodity price volatility, and these fluctuations are often funded with short-term revolving credit facilities. The working capital levels at any point in time may reflect transient variations due to changes in commodity prices, volumes, seasonality (for example, crop seasons in the case of agricultural and weather in the case of energy) or even purchase and delivery contracts (that is, holding product on behalf of clients). If not properly structured and negotiated, the mechanism can be an unforeseen way for a commodity business to lose significant value in a sale transaction.
The concept of a working capital mechanism is that the purchase price determined on the signing date is contingent on receiving an agreed target level of working capital at closing. The target level is often established based on a historical average. If the value of the business is based on the last 12 months’ EBITDA, the average working capital over the same period is likely a good starting point for determining the target. The simplest method of adjustment is a dollar-for-dollar adjustment. If a seller delivers a level of working capital greater than the target amount at closing, it will receive a dollar-for-dollar increase in purchase price. Conversely, if a seller delivers less working capital than the target, the difference will be deducted from the purchase price. An effective working capital adjustment mechanism will help to eliminate the impact of seasonality, shifts in customer demand, changes in payment terms, the addition of new product lines and geographic expansion – to name a few – between the signing and closing dates.
ABC Orange Juice Company
To put this into perspective, let’s look at the following example – depicted in the nearby table – where the owner of an orange juice company agreed to sell his business for $100 million and signed a purchase agreement with the buyer on September 30, 2015. Both parties agreed that the working capital target should be the $35 million of working capital on the balance sheet as of September 30, 2015. The buyer was given 90 days exclusivity to complete due diligence and close the transaction.
Between signing and closing, the owner continued to operate the business in the normal course. However, in October, unseasonably cold temperatures damaged orange crops, and orange prices skyrocketed. To fulfill its floating price order book, the company was forced to purchase its share of the crop at substantially higher prices, which the firm funded via its short-term credit facility. All else being equal, the impact to the balance sheet was a $20 million increase in inventory and a corresponding $20 million increase in the credit facility, both of which are illustrated in the nearby table.
If the purchase agreement did not include a working capital adjustment, then the burden of the weather event would have fallen on the seller. In this case, the buyer would have paid the same price of $100 million, and the seller would have delivered a higher level of inventory than anticipated; however, the seller would also have been liable for the increased debt incurred, depending on how working capital is incurred, and thus receive only $37 million of equity value instead of $57 million. It is worth mentioning that the reverse situation could have occurred. If the price of oranges had plunged, inventory could have decreased, short-term debt would have declined in tandem, and the seller would have been better off.
To avoid this scenario, the buyer and seller incorporated a working capital adjustment clause in the purchase agreement such that there was a target amount of working capital to be delivered to the buyer on the closing date – in this case, $35 million. Any increase or decrease in working capital would be reimbursed on a dollar-for-dollar basis. While the transaction was still completed on a cash-free, debt-free basis, the initial offer price was then adjusted on the closing date, and the seller was able to offset the $20 million of higher debt incurred with the incremental $20 million received through the working capital adjustment. The seller received the equity value expected; the buyer received the target working capital expected as well as incremental working capital that was convertible to the equivalent incremental amount of cash that was paid. Both parties were satisfied with this outcome, as the economics of the deal at signing were maintained.
Determining the Working Capital Target
What, then, is an appropriate working capital target in a sale transaction? Theoretically, it is the normalized level of working capital that enables the buyer to generate the cash flow that is being purchased. In practice, there are various factors that may add complexity to determining this target. For instance, rapidly growing companies often need higher levels of working capital to fund inventory growth. Seasonal businesses see fluctuations in inventory and receivables at different times in the year.
The essence here is that there is no straightforward answer – sellers often focus on the headline enterprise value, but setting the working capital target is a fundamental part of the transaction negotiations and must be mutually agreed upon by both parties.
The best way to get comfortable with potential variations is to perform an in-depth analysis of historical working capital as part of the negotiation of a letter of intent.1 Sellers should define working capital clearly and develop a strong rationale for the inclusion of any atypical balance sheet accounts that should be included. Working with advisors who are familiar with the industry norms as well as precedent transactions can provide a good reference point for the negotiations and ensure that there are no surprises at the closing.
Fluctuations in working capital are natural for most businesses, but the impact is exacerbated for commodity-based businesses where inventory represents a large portion of the balance sheet, has the potential for large swings given price fluctuations for the underlying commodity and tends to be financed with short-term secured debt. Working capital adjustment mechanisms are often a complex point of negotiation for both buyers and sellers in the context of acquisition agreements, in part because they lie at the intersection of corporate finance, accounting and law. However, a well-advised buyer or seller should be able to construct the adjustment mechanism that facilitates the transaction and protects both sides from potential value shifts as a result of changes in working capital. Addressing working capital early on in negotiations and closely coordinating among the accountants, attorneys, internal finance staff and the deal team will prevent a working capital dispute from derailing the transaction.
The Corporate Advisory Group (CAG) is dedicated to building and expanding relationships with clients and prospects of Brown Brothers Harriman (BBH) Private Banking through an objective long-term corporate finance dialogue. CAG operates outside of the traditional transaction-focused, success fee-based investment banking model. As a result, CAG is able to approach clients’ unique needs without bias for any particular outcome and provide advice to best help clients achieve their business and personal goals and objectives. For more information on CAG, please contact your BBH relationship manager or Charles Shufeldt, Head of Corporate Advisory, at Charles.Shufeldt@bbh.com.
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1Letter of intent: an initial written document that sets out the key terms of a proposed transaction, such as the price and structure.