By Don Schaeffer, Managing Partner
Business owners who negotiate a sale transaction without the assistance of a professional M&A advisor tend to focus heavily on purchase price negotiations in terms of a multiple of Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA) or revenue; however, there is an equally important negotiation that is often overlooked that can impact total transaction value by potentially millions of dollars: the working capital deliverable at closing.
The concept of working capital and its central role in deal negotiations is confusing to some owners who mistakenly believe that buyers will pay the seller both the value of the company based on a multiple of earnings or revenue and additional consideration tied to shareholders’ equity delivered at closing, much of it in the form of working capital, defined as Current Operating Assets minus Current Operating Liabilities. Buyers will assume these operating assets and liabilities at closing, but do not make a supplemental payment. Sellers are required to deliver a snapshot balance sheet at closing that includes working capital levels that reflect “average, ordinary course” business activities. Depending on the company, industry, and seasonality or cyclicality of the company, working capital as a percentage of sales can vary widely. What is normal for one company could be quite different for another in the same industry, depending on how adept companies are in collecting Accounts Receivable or maximizing Inventory turns, as examples.
Below are primary working capital components for most companies:
Current Assets: Cash, Accounts Receivable, Inventory
Current Liabilities: Accounts Payable, Accrued Expenses
As part of our advisory services, De NES Partners spends a fair amount of time evaluating our clients’ working capital levels on a historical, monthly basis to ensure that when it comes time to negotiating a reasonable level of working capital to be delivered at closing, our clients are treated fairly. We prefer to advise potential clients months or years in advance of a transaction to encourage operational improvements in the interim, particularly A/R collection efforts or inventory management in order to reduce “normal course” working capital needs of the business so that money is not unnecessarily left at the table during deal negotiations. While buyers frequently point out pegging working capital is not an exercise to extract purchase price reductions out of sellers, De NES Partners’ experience has been that uneducated sellers fail to realize the importance of this negotiation and underestimate buyers’ keen ability to claw back purchase price.
The best way to demonstrate De NES Partners’ skill in assisting clients in maximizing transaction value by limiting working capital deliverables is by way of example of successful negotiations for former clients:
Case Study #1:
Client: Wholesaler/Installer of Consumer Goods*
Situation: Our client was satisfied with the purchase price, but was not entirely focused on the dollar amount of potential, normal course working capital that would have to be delivered at closing. Our client had experienced fast revenue growth in recent years, but as a consequence, its working capital needs were accelerating at a faster rate due to a growing accounts receivable balance as builder clients’ cash needs to support residential home construction were growing.
Outcome: In the final days of definitive purchase agreement negotiations, the De NES Partners Principal prevailed upon the buyer that the seller’s growth rate would be slowing in the coming months and that the balance sheet 6-12 months prior was more indicative of what should be expected shortly after closing. The De NES Partners Principal asked that the company deliver millions less in working capital than what had been initially proposed. The buyer agreed, and the client was ecstatic as we helped our client pocket $5 million in additional transaction consideration, more than covering our advisory fee.
Case Study #2:
Client: Specialty Construction Company*
Situation: The company had largely negotiated the purchase price with a buyer, but hired the De NES Partners Principal to assist with getting the remaining deal points negotiated. With the exception of reviewing the balance sheet to request the removal of personal assets, the owners had spent little time evaluating the company’s historical working capital levels. Upon being hired, the De NES Partners Principal informed the client that if we could not push the buyer to increase the purchase price, based on comparable sale multiples in the industry and the public company buyer’s own valuation, there is another way to improve overall transaction value: by lowering the working capital to be delivered at closing. The De NES Partners Principal immediately started reviewing the company’s historical, monthly balance sheets and noted that “normal course” working capital that the buyer was requiring to be delivered was unusually high. Our client indicated that construction project bonding requirements were such that it always kept high cash balances just in case an unusually large project surfaced, plus it needed to comply with its insurance bonding agent’s requirements. The company’s growth rate was expected to slow to the point that the annualized project revenue run-rate as a multiple of working capital had narrowed, well below bonding company requirements for working capital.
Outcome: In the final days of definitive purchase agreement negotiations, the De NES Partners Principal prevailed upon the buyer that the buyer’s requirement for working capital at closing was unreasonable as the future working capital needs would not be as onerous due to slowing revenue growth and because the bonding requirements were such that based on flat revenue projections, the company was carrying too much cash on its balance sheet, thereby overstating working capital needs. The De NES Partners Principal prevailed upon the buyer that the current bonding liquidity requirements suggested that the company should be delivering $11 million in working capital at closing. The buyer agreed, and our client pocketed an additional $10 million in consideration. Our client was thrilled with the outcome.
If you would like to learn more about the mechanics of working capital negotiations or need assistance in determining the estimated value of your business, please contact Don Schaeffer at (770) 858-4493, dschaeffer@deNESpartners.com or visit us at our website at: www.deNESpartners.com. De NES Partners always provides a no-cost valuation estimate to business owners seriously considering the sale of their business with absolutely no obligation on their part.
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* These transactions were completed by a De NES principal while at a predecessor firm