Working Capital (WC) is often an overlooked component of an M&A deal by sellers, but it should be an area of focus because it can result in an actual exchange of money between buyer and seller.
The simple definition of WC is current assets minus current liabilities, but that becomes more complicated in an M&A deal. M&A deals are commonly “cash-free debt-free,” meaning the seller can keep the excess cash on the balance sheet but is responsible for paying off any debt, as the buyer will not assume it.
As part of the deal, the buyer will require that the seller leaves a certain amount of cash-free debt-free WC in the business at close. This is known as the “working capital peg,” and in common corporate speak, “leaving enough gas in the tank.”
Most commonly, a buyer will include in their LOI that the enterprise value assumes “adequate working capital” and that the peg, methodology, and any adjustments are “subject to accounting diligence.” Sellers are left wondering what that means. Approaches vary, but at Persient we always push for more detail than less in an LOI, as it leads to less uncertainty and required negotiation as the purchase agreement is drafted, and a timelier close.
Of course, regardless of the definition of WC in the LOI, it is still subject to diligence, which is understood. But, at minimum, a seller wants general guidance as to how the peg will be calculated. Will it be based on average of last 12 months? 6? 3? What about contentious current liabilities like deferred income and customer deposits, will those be included in the calculation or treated as debt-like (debt-like requires a separate discussion and probably a separate post)? Ideally, this is reasonably defined and agreed on between buyer and seller prior to LOI signing.
Likely two weeks or so before scheduled closing, buyer will provide their working capital peg calculation to seller, which has been subjected to due diligence by buyer’s accounting firm. This calculation will have several adjustments, many of which are obvious, and some of which may leave the seller scratching their head. From there, it is a negotiation between buyer and seller to settle on a peg. It often requires several back-and-forth exchanges.
Once the peg is agreed, the seller must deliver that amount of WC at close. If less than the peg is delivered, the seller owes the dollar-for-dollar difference to the buyer. If more than the peg is delivered, the buyer owes the dollar-for-dollar difference to the seller. Let’s apply dollar figures for example. If the peg is calculated at $1 million, and seller delivers $700,000 at close, then seller must pay an additional $300,000 to buyer at close. That’s a real impact on the pocket. There is also a “collar” concept, which can be negotiated between buyer and seller to not exchange money if WC falls within a certain threshold (e.g., $50,000 in either direction).
The WC delivered at close will be a best estimate calculation by the seller. Post closing, seller and buyer will do a “true-up” of WC alongside the buyer’s accounting firm and determine if any additional exchanges of money are needed. If there are disagreements with the calculation which cannot be remediated, the purchase agreement should provide for next steps, which typically involves engaging an independent accounting firm to assist.
TLDR: Working capital is an important and confusing element of M&A deals, which all too often is overlooked by sellers and can result in a real impact on seller proceeds. If you’re a seller, please make sure you’re discussing working capital with your M&A advisors and legal counsel.
