WHY WORKING CAPITAL MATTERS IN YOUR SEARCH FUND ACQUISITION
In any acquisition, large or small, the last place to get or lose value is the negotiation over working capital. Many searchers overlook this critical deal point or fail to understand its importance. No matter what kind of company you are buying, you would be well advised to get ahead of the curve and negotiate hard on working capital early in the deal process. Unsophisticated sellers may not fully understand the importance, which may work to your advantage. Regardless of the circumstances, you don’t really know how good or bad a deal you have until you know how working capital will be handled in the transaction.
The most common way to compare the enterprise value of transactions is to look at multiples based on a debt- and cash-free company changing hands. But there is more than meets the eye to every transaction.
Working capital is defined as the capital used in a business’s daily activities, or current assets minus current liabilities. It includes things such as cash, payables, receivables, inventory, and work in progress. It can include payroll or variable compensation accruals, deferred revenue, and current tax liabilities.
Every business is different depending on how it is conducted and the industry it is in. During the acquisition, a good term sheet should include both a definition of working capital for the specific situation and an agreed-upon peg that the seller must deliver to the buyer at closing, with cash as the final variable to reach the pegged working capital amount. Note that working capital does NOT include deal expenses or anything related to current debt.
As a potential buyer, the first thing you need to do is figure out how working capital has functioned in the target company historically. How quickly does it pay its bills? How quickly does it collect receivables? Is there inventory and, if so, how much? Do its customers pay in advance, creating deferred revenue? Are there significant bonus or sales commission programs that create liabilities throughout the year? What has been its historic level of working capital excluding cash? (I say excluding cash because we are still talking about buying a debt- and cash-free company, except in the case where the working capital delivered falls short of the peg and the seller has to leave cash on the balance sheet to make up for the shortfall.)
Here’s the thing: the working capital peg is directly correlated to value even if it doesn’t show up in the headline multiple in any given deal. So, you want to be fair but also avoid getting screwed. (Believe me, I have been there when the buyer in a $1.4 billion transaction was smart enough to grab $20 million of value by saying the working capital peg should exclude deferred revenue and then pointed at me, a lowly finance guy at a big company selling a division of our business, and said that I had already agreed to it.)
Here are some things to consider.
Payables and Receivables: In a profitable business, you will have more receivables (revenue) than payables (expenses) in aggregate, but it may be that receivables are collected more slowly. What you don’t want is for the seller to collect all the receivables and leave you with all the payables. It is generally fair to see how these have historically settled out and use that number here. Note that whether the receivables are collectible is a separate issue and one you will need to resolve in diligence.
Deferred Revenue: This is revenue that the customer paid for in advance. It is quite frequently the case in recurring revenue businesses that the company will have the market power to demand that customers buy well in advance. I was involved in a market research business where we sold customers three years of data and got paid for it upfront. Here’s the thing about deferred revenue: when you buy the company, that is the top line of what you now own. But the cash is already in the bank. In my opinion, that cash has got to come with the business. Deferred revenue is a current liability. It should be included in the calculation and, all other things being equal, the peg should be zero, forcing the seller to leave cash equal to deferred revenue.
As a side note, FASB has recently changed the rules for purchase accounting for deferred revenue once you own the business. Please read up on that issue here: “Beware of disappearing revenue in an acquisition.”
Payroll and Bonus Accruals: My view is that these are expenses that occurred prior to my taking over the business, but no one paid for them. They are current liabilities, so they should be included, and the peg should be zero, forcing the seller to leave enough cash on the balance sheet to pay their share of these expenses when they are due.
Inventory (Raw Materials/Work in Progress): This applies mostly to manufacturing companies that sell a physical product, which are uncommon but certainly not unheard of as search acquisitions. Here you want to look at historic norms and add that amount as a positive number to the peg. You don’t want the seller using up all the inventory in the weeks prior to close so that you have to replenish inventory out of your pocket.
These are just a few things to consider; this is not a comprehensive list. In general, you as the buyer want the peg to be higher, and the seller wants the peg to be lower. The seller will want to exclude portions of current liabilities and include all current assets in the definition of working capital. You will want the reverse.
My advice is to be fair, use common sense, and make sure that you get a company that has the working capital you need to not miss a beat when you take the helm. But get it agreed to early in the process, not late. It’s a material term to any offer, and the quicker you come to an agreement on the definition and the peg, the less opportunity there is for confusion and the inevitable legal fees associated with going back and forth with the seller.