Why negotiation on working capital is key for M&A transactions

Why negotiation on working capital is key for M&A transactions

Working Capital is generally one of the key considerations in an M&A transaction. It is often a subjective and complex area, with implications on the total consideration payable.

What is normalised working capital in M&A transactions?

In a typical transaction, a Buyer and Seller will agree on an Enterprise Valuation of the target business. Enterprise Value can be arrived at by utilising various valuation methodologies, but the most common approach is to apply a multiple to the target company’s Maintainable EBITDA/Earnings.

The Enterprise Value is what the business is worth on a cash-free, debt-free basis and assuming a normalised level of Working Capital. It is implicit in an earnings-based valuation that the target company will have sufficient Working Capital at completion of the transaction to maintain such level of earnings, without any immediate liquidity issues. The difficulty comes in determining what is a ‘sufficient’ level of Net Working Capital.

How is normalised working capital addressed in M&A transactions?

Working Capital is generally addressed at the outset of a transaction. The Heads of Terms usually specify the purchase price, with it noted that this is subject to a normalised level of Working Capital at completion (a normalised Working Capital ‘Target’ is established as part of the financial due diligence).

On completion, if the Net Working Capital is higher than the ‘Target’, the Buyer often pays the Seller an incremental amount, which effectively increases the purchase price, and vice versa. It is therefore in the Buyer’s interest for the ‘Target’ to be as high as possible, whereas the Seller will want this to be as low as possible.

The ’Target’ also safeguards both the Buyer and the Seller from any one-off Working Capital movements or trends in the run up to completion, for example:

If, in the run up to completion of the transaction, a large customer who typically pays within 60 days suddenly pays an invoice early, the Company’s cash balance will have increased. As the deal is Cash-free, Debt-free, the Seller’s proceeds will be increased, however the Buyer will be left with a Trade Receivables balance which is below ‘normal’ levels. (normal levels would have been 60 days). This scenario would be caught by the ‘Target’ Working Capital, as at completion, the Working Capital is likely to be lower than the ‘normalised’ (Target) levels, and an adjustment would be made accordingly to the purchase price.

It removes the temptation for Sellers to restrict the payment of creditors to improve the cash balance of the business on completion. The Working Capital at the completion date will be correspondingly lower, and therefore see a reduction to the purchase price when measured against the ‘Target’ Working Capital.

How is normalised working capital calculated?

Exactly what the normalised Working Capital is for any target company is subject to financial due diligence, and generally a negotiation between the Buyer and Seller. Unhelpfully, there is no standard definition on how to calculate a normalised Working Capital ‘Target’. Therefore, it is normally a key negotiation during a transaction between a buyer and seller and their respective advisors, and can lead to potential value gain / loss for either party should the ‘Target’ not be set at an appropriate level.

A typical negotiation process would include:

1. Establishing cash vs debt-like items:

This process may sound easy, but there are often various components which require negotiation. For example, when cash has been received from a customer for a service/product which has not been delivered yet, known as deferred income. It can be argued either way whether this is a debt-like item, or a Working Capital item. Including this in Working Capital is more beneficial to the Seller, whereas if it is defined as a debt-like item, it is more beneficial to the Buyer.

2. Establishing which items relate to working capital:

An assessment is carried out of the normal Working Capital. Typically, this is measured over the last 12 months or based on a future period if the Enterprise Value is calculated based on the future performance of the target company.

The Buyer (and Seller) will prepare an analysis as part of the financial due diligence. This review will typically include consideration of Working Capital trends and any one-off large movements in certain Working Capital items.

How is value impacted?

Once the transaction has been concluded, there is typically a set of Completion Accounts prepared. This will determine the level of Completion Cash and Debt, as well as Completion Net Working Capital – which is then compared against the ‘Target’ Working Capital.

Under a Locked Box completion mechanism, this adjustment will have been agreed as at a date before completion, which will result in a known adjustment to the purchase price having been made, however, the same principles noted above will still apply.

If the Net Working Capital at completion of the transaction (or as at the Locked Box date) is higher than the ‘Target’, the purchase price is increased by the incremental amount, pound-for-pound. Vice versa, if the completion Net Working Capital is below the ‘Target’ then the price may be adjusted downwards.

It is vitally important that both Buyers and Sellers undertake a thorough assessment of Net Working Capital, to ensure that a sufficient Working Capital ‘Target’ is set. We would always advise parties entering a potential M&A process to engage with Corporate Finance experts in advance of negotiations on Working Capital. The AAB Corporate Finance Team has extensive experience in supporting both Buyers and Sellers throughout this process, achieving significant value for our clients in the process.

 

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