The Working Capital Conversation You’re Having Too Late

What does cash-free, debt-free have to do with working capital? Well, pretty much everything. Your purchase agreement will define what happens with every single line item on the balance sheet. Specifically, each line item within assets and liabilities will fall into one of three categories:

• Be considered cash — what you get to take home as part of your proceeds
• Be considered debt — what you have to pay off and reduces your proceeds
• Be considered net working capital — the operating liquidity that stays with the business, for the business to be a going concern (i.e., be able to fund operations and meet short-term obligations)

As a formula, this can be succinctly represented as:

The above enables the buyer to effectively start with a clean slate.

Clean items that constitute cash are bank balances, but you may split hairs over items such as restricted cash, escrow accounts, outstanding payments, payments in transit, or insurance-related distributions. Clean items that constitute debt are interest-bearing debt (e.g., lines of credit, loans), accrued income taxes, and deferred taxes, but you may split hairs over items such as customer deposits, deferred revenue, aged receivables and accounts receivable reserves, extended payables, and accrued bonuses and commissions.

Now for the important part. For those contemplating M&A or undergoing a transaction, have the working capital discussion as early as possible — don’t leave it to the end. Not only can the negotiation of net working capital have a material impact on your purchase price, it will almost certainly delay the signing of your transaction if you don’t address it in time. And as a consequence, it can lead to a re-trade of value or even worse, broken processes.

The way you navigate this with one buyer is also significantly different from how you would navigate it with multiple buyers (i.e., in an auction process). Much more important to address early when you are dealing with only one buyer.

Some of you may be wondering — well this has all been great, but how exactly am I setting this net working capital, and how does this impact my purchase price? Two ways this is typically done:

• Net working capital peg and completion accounts — how typically done in the US
• Locked box mechanism — how typically done in Europe

Largely a product of convention — US deal culture hardened around post-closing adjustments, while European deals gravitated toward price certainty at signing. Neither is objectively better, but good luck having a uniform standard.

If this is helpful to you, feel free to subscribe. And stay tuned, I’ll walk through the above two methodologies in subsequent publications.