From the Legal Corner – Working Capital

Sep 26, 2014

IBA, as the premier business brokerage firm in the Pacific Northwest, is firmly established as a respected professional service firm in the legal, accounting, banking, mergers & acquisitions, real estate, and financial planning communities.  Periodically, we will post guest blogs from professionals with knowledge to share with for the good of owners of privately held companies & family owned businesses.  The following blog has been provided by David Cook of Sovereign Legal.

The Dollars in the Details

{Def: current assets minus current liabilities}. Sounds simple, right? Almost never. Who gets what piece of this pie? It’s an often overlooked area, and one where it literally pays to consult your deal advisors and do the analysis early in the process. We’re not talking about legal hypotheticals & risk management folks, we’re usually talking about tens or hundreds of thousands of dollars!

Valuations and LOIs impliedly, but rarely explicitly, assume an “adequate” or “normal” amount of WC. Buyers want to ensure the business has enough WC to meet short term operating requirements, without having to infuse additional cash. Sellers, on the other hand, want to take all the cash out of the company, or at least get compensated for all the business they have already performed. But what is “adequate” or “normal”, and how do we structure the deal to take into account a moving target?

The most common approach is to structure the deal with a “Target” WC amount, with a post-closing adjustment, dollar-for-dollar, based on a “look-back” balance sheet retro to the date of closing. This captures such things as payables arising before the closing but not invoiced/received until after.

Ok, that sounds straightforward enough, but what about setting that “Target”? Working capital needs vary greatly from company to company, and often within a company from season to season or year to year. Here are some factors to consider with your broker and CPA:

–        Seasonality. In businesses with highly seasonal sales, WC may vary significantly. If, for example, a transaction closes when the cash from holiday sales have already come in (and gone out to the owner), and new inventory/materials need to be acquired, what might otherwise be “normal” working capital is probably not “adequate.”

–        Growth. If the company is on a growth trajectory, its working capital needs are likely growing along with sales, and historical working capital is not likely a good indicator.

–        Replacement Cycles. If, based on a buyer’s due diligence, they determine that the business needs new key equipment or other major expenditures that should be factored in. One common approach is to look back several years, in some cases as much as ten, and consider the nature of the equipment, the useful life, and normalize/average replacement costs over that period.

–        Receivables. Is the A/R being sold? If so, is there a “guarantee” mechanism (i.e. Buyer will pay a maximum of 90% of value of A/R on the balance sheet at closing; or Seller will be charged back for any A/R not received within 90 days of closing). This should be factored into your approach to WC requirements and post-closing adjustment.

Another issue is the actual mechanism for making the “look back” adjustment – how will it be paid? If part of your transaction is a seller holdback note, that is often the best vehicle; simply adjust the note balance based on the final calc. If not, you may need an escrow agent with well-drafted escrow instructions. And what about disputes over the calculation? You’ll want carefully constructed provisions providing for selection of independent CPAs to settle issues. Finally, whether you’re the buyer or seller, you’ll want to set the framework for this up front, in your LOI, or at least leave some flexibility of language that doesn’t subject you to being perceived as “changing the deal” when it rears its head again later.

-David Cook is managing attorney at Sovereign Legal, a business transactions law firm based in Seattle.