You Can’t Have Your (net working capital) Cake and Eat it Too
By Sean R. Saari, Partner, Advisory Services
At some point in all of our lives, someone has told us (or we have had to tell our children) that “you can’t have your cake and eat it too.”
This figure of speech illustrates the concept of trade-offs (if you eat your cake, you don’t have it anymore), a key component of every merger and acquisition transaction. Rarely does a deal close without both parties making compromises from their ideal scenarios in order to reach an agreement. If a buyer or seller faces an issue in which they demand to be in the superior position regardless of the outcome (and to the detriment of the other party), they may be trying to “have their cake and eat it too.”
In my earlier blogs, we talked about one of the issues we have seen creep up in previous negotiations as it relates to the treatment of net working capital (NWC) in an acquisition and its impact on the purchase price.
The definition of what constitutes NWC can differ in each transaction, but it generally is equal to non-cash current assets (accounts receivable, inventory, prepaid assets) less non-debt current liabilities (accounts payable and accrued expenses). The amount of NWC that a company needs to operate effectively differs by industry (and to some degree, even by company). For example, service businesses generally have lower NWC requirements because they can collect cash payments when their services are rendered and have lower inventory requirements. Manufacturers, on the other hand, often have more significant NWC requirements as a result of inventory balances and larger accounts receivable (for products shipped to customers prior to receiving payment). To the extent that a business has deficient (or excess) NWC as of a valuation or transaction date, it will correspondingly decrease (or increase) its value.
The issue we have seen regarding the treatment of NWC in transactions can occur when the purchase price for a company is based on income or market-based valuation approaches (both of which generally assume that the company is delivered with an appropriate amount of NWC at closing). For example, if the parties in a transaction can agree on the purchase price for a business based on these valuation approaches, but the seller also wants to retain all of the uncollected accounts receivable of the business (which are significant), then the business is likely to be delivered to the buyer with a deficient amount of NWC.
This means that unless the purchase price is adjusted downward for the expected NWC deficiency, the buyer will end up overpaying for the business because it will need to fund the NWC shortfall out of its own pocket. In other words, the seller may be trying to have its cake and eat it too. Knowledgeable buyers, however, will not pay full price for a company that is being delivered without sufficient NWC. Therefore, unless the seller is willing to adjust the proposed purchase price for the potential NWC deficiency (in our case, the assumption is that the seller wants to retain all uncollected accounts receivable), it is unlikely that a deal will be reached.
We have generally found it to be a best practice in transactions for the buyer and seller to reach an agreement on a NWC target (which is typically based on the selling company’s historical NWC levels). To the extent that the selling company’s NWC is in excess of (or less than) the target amount on the closing date, the purchase price is generally increased (or decreased) on a dollar-for-dollar basis.
With this in mind, transactions can be structured in a number of different ways as far as which assets and liabilities are retained by the seller and which are transferred to the buyer. The NWC target ensures that the purchase price is adjusted accordingly for these structuring differences as well as any material increases or decreases in NWC levels between the time that the target is set and closing. At the end of the day, the seller should end up with the same value for its business whether it is comprised entirely of a cash payment or is a mix of cash and retained assets.
Having your cake and eating it, too, sounds great, but if you aren’t willing to share (by making trade-offs and compromises where appropriate), you may end up eating alone.
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