Before discussing how to minimize the impact of the Net Working Capital issue, it is important to understand what we mean by Net Working Capital and the significance of Net Working Capital to the structure of a transaction.
To start, it is important to highlight that when a buyer and seller agree to a purchase price for a business, there are effectively two elements to that purchase price: the net tangible assets and the goodwill or intangible asset value. The net tangible assets represent the hard assets of the business (i.e. cash, accounts receivables, inventory, equipment etc.) net of any liabilities or obligations. The goodwill or intangible asset value, on the other hand, represents what we refer to as the soft assets that you can’t necessarily touch and feel but are integral to the business (i.e. know-how, customer lists, brand, reputation, location, etc.).
Given the nature of these two components, there is generally more risk associated with the goodwill and intangible assets (a bank is more likely to use tangible assets as collateral versus intangible assets) and so a purchaser will want to limit the portion of the purchase price attributed to the intangible component. Furthermore, a purchaser will also want to establish a set target for the net tangible assets of the business to be left at closing so that the seller doesn’t strip out all of the net tangible assets required for operations and thus leave the purchaser with a higher proportion of goodwill value than what was agreed to when the purchase price was established. On the other side, the seller does not want to leave in excess net working capital as this otherwise reduces the value of the goodwill that they intended to realize on the sale.
Given the above considerations, it is normal that some type of target or “peg” is established for the net tangible assets required to float the operations of the business on a daily basis and that a corresponding “purchase price adjustment” be put in place to ensure the final transaction is fair relative to the peg that was originally negotiated and agreed upon. The Net Working Capital of a business tends to be the most common basis for setting this peg since it does represent a fairly good proxy for net tangible assets or what net assets are needed to operate the business (excluding fixed assets). While there are a couple of variations that get considered, Net Working Capital itself effectively represents the current assets minus the current liabilities of a business with the current assets and current liabilities being as defined by Generally Accepted Accounting Practices.
Keeping this background in mind, what we advise clients who are considering a potential sale transaction is as follows:
- Understand the History – The setting of the Net Working Capital target for a sale transaction is most commonly determined by looking at a historical average leading up to the closing date of the sale. This historical average is normally calculated based on monthly balances and the time period will usually range anywhere from six months to twenty-four months. As such, before going down the road of the transaction, it important that you analyze and understand the historical working capital of the business.
- It’s Not Just the Dollars and Cents – It’s not only important to understand the actual dollar amounts of the Net Working Capital but other ratios as well. Net Working Capital will fluctuate for a business depending on seasonality, growth of the business and a number of other factors. Thus, looking at metrics such as current ratios (current assets dividend by current liabilities) and Net Working Capital as a Percentage of Revenues (normally based on trailing twelve months of revenues) are vital to help assess and understand what has taken place and needed for the business to properly operate.
- Identify Abnormalities – When you are looking to understand what has taken place, try to identify any unusual circumstances that might have impacted working capital. For example, you need to consider whether there was any one-time large purchases of inventory completed in order to take advantage of favourable pricing discounts? If so, this may have inflated the inventory and temporarily skewed the corresponding Net Working Capital at this point in time. The other common abnormality that we see is attributed to the fact that proper bookkeeping is not maintained on a monthly basis. For example, if inventory is not adjusted in the accounting records on a timely basis, then it can potentially skew the monthly analysis.
- Work with Your Accountant to Understand the Net Working Capital – Not only are the different ratios important to completing an assessment of the working capital peg, but there are a number of other ways to slice and dice the Net Working Capital Analysis. Considerations include the exclusion of cash and/or financing-related balances, eliminating related company balances and or other specific current asset and current liability balances that might not be relevant to the transaction.
- Managing Net Working Capital Leading Up to the Eventual Sale – Once you are equipped with the above information, you can then take the necessary steps to better manage the Net Working Capital in the period leading up to the sale. We commonly see circumstances where vendors have been conservative in their working capital management since it provides a level of comfort to them when they operate the business. However, a purchaser can use this conservatism as a means for setting the working capital target higher given what has historically been in place relative to recent conservative practices. This, in turn, has a negative impact to the seller as the purchase price that they are able to realize would be lower, all else equal, due to these conservative measures adopted just prior to a sale.
- Set the Net Working Capital Target Early in Negotiations – In an ideal world, the Net Working Capital target is something that should be identified and set out in a Letter of Intent
(“LOI”) that is provided by the potential purchaser. In practice, this is sometimes difficult depending on the amount of disclosure that a seller is willing to provide to the purchaser. If it is not possible to have the inclusion of the target in the LOI, then steps should be taken to get the Net Working Capital target agreed upon as soon after the LOI’s completion as possible, in order to avoid the conflict noted in the introductory part of this blog.
- The above considerations will not only better prepare you for the sale process, but they will also help to ensure that you maximize the eventual ‘take-home’ proceeds from the sale. Having this information in advance of any discussions with a potential vendor will also let the purchaser know that you’ve done your homework and should minimize any potential conflict and the purchaser’s ability to negotiate the purchase price down.