Working capital disputes are one of the most common reasons transactions fail. When selling a business, the common practice in most industries is that the business is priced on an Enterprise Value basis. This means that the price assumes the business will be acquired with no cash, debt, taxes owing or redundant assets/liabilities. Let’s break this down:
- Cash – non-operating cash is removed from the business and remains with the vendor.
- Debt – All debts including shareholder loans, capital leases, etc. are to be settled. Therefore, the vendor must payout debtors or transfer debt out of the business prior to closing. It can also be negotiated that the debt is to be retained by the purchaser, and the price of the offer is reduced.
- Taxes – The vendor will be responsible to pay all taxes for the profit up to the date of sale, and the purchaser will be responsible for all taxes from their date of ownership forward.
- Redundant assets/liabilities – includes all assets and liabilities that are owned by legal entity but are not involved in the core business cash flow generation.
Enterprise value also requires that the business is delivered to the purchaser with the requisite assets to operate, which includes a normal level of working capital.
Common areas of misunderstandings and conflict in a divestiture:
- The vendor thought they would receive additional payment for inventory on top of the price offered by the purchaser.
- The vendor and purchaser disagree on what normal working capital for the business is.
- A dispute regarding the closing working capital arises post-closing the transaction.
How working capital mechanisms work?
Before diving into the mechanics of the target net working capital mechanism, let’s define net working capital. Net working capital is the difference between a company’s current assets (accounts receivable, inventory, prepaids) and its current liabilities (accounts payable, accrued expenses). It represents the amount of capital a company needs to operate its business on a day-to-day basis.
The Target Net Working Capital is the balance of net working capital the business needs to be operational and generating profit. Determining what level is required to generate the business profit is usually determined based the company’s historical performance and the working capital requirements of its industry. A common technique for determining normal working capital is to look at the average working capital at each month end for the trailing 12 to 24 months.
If the actual Net Working Capital at closing is higher than the target Net Working Capital, the vendor will receive an increase in the purchase price for this excess asset value delivered to the purchaser. Inversely, if the actual Net Working Capital is lower than the Target Net Working Capital, the purchase price will be reduced, and the vendor will pay the shortfall to the purchaser.
Why does a target net working capital mechanism make sense?
The target working capital mechanism incentivizes the vendor to operate the business in normal course through the divestiture process. Said another way, there is no incentive to artificially stockpile inventory, demand quick collection, or drag out payments to vendors (a.k.a. no funny business). The net cash position of the vendor at the time of sale is not impacted by their working capital decisions immediately prior to completing the transaction.
Example A: If there is a favourable price to acquire inventory prior to close, the vendor uses cash to purchase the inventory and is incrementally paid for that inventory in the working capital mechanism.
Example B: The vendor calls their top customer a requests quick payment of all outstanding invoices prior to close. The vendor has more cash in the bank at closing which they retain; however they have reduced working capital and will pay that back to the purchaser through the working capital mechanism.
How do you prepare your company for sale?
The main objective of a seller is to negotiate a lower Target Net Working Capital. The best case for demonstrating the working capital needs of the business is the historical data. It is difficult to argue, “I could choose to collect from customers faster, if I wanted to” when the customers have a history of taking long periods to pay. Therefore, the best practice is to operate the business with the best collection and payment policies your customers and vendors will permit, so the historical financial data represents the least working capital investment possible. This also means keeping current records that writes of bad debts promptly and does not maintain receivables or payables on the books that are not collectable or payable.
Steps you can take immediately to improve your Company’s target working capital for a future sale:
It is best to implement these changes in advance of considering a sale process so a track record of working capital efficiency is demonstrated in the data to purchasers:
- Write-off bad debts so they are not artificially increasing your working capital position;
- Establish timely collection practices and be diligent following up with slow payers;
- Negotiate quicker collection terms with customers.
- Write-off obsolete or unsaleable inventory so it is not inflating monthly working capital;
- When strategically purchasing excess inventory, make note of the large purchase and communicate this to your investment banker for normalization. This is common in commodity businesses such as steel manufacturers that may stockpile input materials when prices are favourable.
- Pay bills at their due date and not beforehand. Of course, it is important to maintain good vendor relationships, so cash flow generation of the business is not impacted;
- Negotiate longer payment terms with vendors.
- Business owners should ensure that their accrued expenses are accurate at each month end. Accrued expenses include items like employee bonuses, vacation time, and other liabilities that have not yet been paid.
The target net working capital mechanism is an essential component of any sale agreement. It ensures that the buyer is purchasing a company with the appropriate level of working capital needed to sustain the business after the sale. Business owners should carefully consider the factors outlined above when preparing their company for sale to ensure that their working capital is in line with industry standards and that there are no surprises at closing. By doing so, they can maximize the sale price and ensure a smooth transaction for all parties involved.
Josh Ellis, CPA, CA, CBV
Vice President, Toronto
Josh advises clients on complex divestiture and corporate finance processes across a broad range of industries including consumer package goods, industrial manufacturing, business services, oil and gas services, and more. As a lead member of CCC’s valuation practice, Josh takes a practical approach to valuations which is focused on the user’s needs, while adhering to CICBV standards. Josh is a member of the CICBV continued professional development committee.