Ask someone who has sold their business which part of the deal caused the most stress and there is a good chance they will say it was the working capital adjustment.
“Working capital is often the most heavily negotiated portion of the deal,” said Ann Hanna, managing director at Milwaukee-based Taureau Group.
Working capital is the difference between a company’s current assets, including cash, accounts receivable and inventory, and its current liabilities, such as accounts payable and short-term debt. However, some assets or liabilities may be excluded. As part of the deal, a buyer and seller will agree on a working capital target, generally based on historic averages. At closing, the difference between actual working capital and the target will result in the purchase price being adjusted up or down.
It is meant to be a mechanism to make sure the acquired business has the working capital needed to operate going forward while also accounting for normal or seasonal fluctuations in a business.
“At its core, this mechanism is meant to ensure that there is no detriment or benefit to either the buyer or seller due solely to the timing of the transaction’s close,” said Nick Kozik, director at Milwaukee-based TKO Miller.
Hanna suggested those new to the sale process “should be careful to avoid the temptation to defer the working capital conversation to later in the process because it seems small, easy or straightforward.”
“It is a complex mechanism that often involves material dollars and can absolutely be manipulated to benefit one side or the other,” Kozik said. “So, it is very important that inexperienced sellers (or buyers) take time to fully understand the adjustment and all of its moving parts – or have an advisor that does – before agreeing to a final working capital adjustment.”
To get a better sense for why this portion of the deal poses challenges, BizTimes reached out to Hanna and Kozik, along with John Emory Jr., president of Milwaukee-based Emory & Co., and Robert Jansen, managing director of Milwaukee-based Bridgewood Advisors. All four are investment bankers working in southeastern Wisconsin. Each provided their responses to questions on issues with the working capital adjustment and things buyers and sellers should keep in mind:
BizTimes: Why is the working capital adjustment frequently a pain point in transactions?
Ann Hanna: “While the intent is to provide a neutral, level playing field between buyer and seller, how the playing field is drawn can be very subjective. With supply chain issues and raw material price increases we saw in 2021-2023, inventories held and inventory dollar values have been skewed, so a historical look back can be very difficult and not representative of working capital needs. Working capital, by definition, sounds very easy to calculate and very straightforward – it is not either of those.”
Nick Kozik: “Anything that results in a change to the proceeds at close tends to have the potential to be controversial, but I think that there are two factors that contribute the most to the working capital adjustment becoming a particularly contentious aspect of negotiating a transaction: One, sellers who are often less experienced in doing transactions do not entirely understand the purpose and mechanics of the working capital adjustment. The working capital adjustment is not supposed to be a gain or a loss for either side. If the target is set at a fair level that truly reflects the working capital needs of the company, any movement to proceeds, up or down, caused by the working capital adjustment should be offset elsewhere. … Two, buyers who are often more experienced in doing transactions will sometimes try to use the working capital adjustment to capture additional value. While at its core the working capital adjustment is meant to be a neutral mechanism, it is not uncommon for one side (more often the buyer but sellers are not immune) to try to manipulate the working capital adjustment in their favor.”
John Emory Jr.: “Setting the working capital target, or peg, used to determine the purchase price adjustment is often a pain point in transactions for many reasons. The biggest reason, in my view, is that it is a dollar price adjustment up or down for every dollar the closing working capital is above or below the peg. Thus, every dollar that would go to one party comes from the other party, leaving no real room for a ‘win-win’ compromise.”
Robert Jansen: “Beyond the potential economic magnitude, the emphasis on net working capital is driven by complex and often subjective factors, including the business’s growth trajectory, seasonality, excluded assets and liabilities, inconsistent interim accounting, and nonrecurring and intercompany transactions.”
What should sellers keep in mind to best navigate this portion of the deal?
Hanna: “When considering a transaction, both buyer and seller should review historical net working capital to determine the amount of volatility and seasonality in the business. For a business with volatility, seasonality or a skewed history (past 12 months), the parties should address the working capital and, at minimum, agree on a formula prior to signing a letter of intent.”
Kozik: “Try to take a neutral mindset when considering the working capital adjustment. A positive working capital adjustment doesn’t mean you won, and a negative working capital adjustment doesn’t mean you lost.”
Emory: “Among family-owned businesses in the Midwest, it is often a badge of honor to pay bills very quickly, much faster than their customers pay them, which often leads to an imbalance of larger receivables than payables. Corporate buyers, such as private equity groups or large strategic buyers, will plan to stretch out their payment of payables compared to the extremely fast payment of family-owned companies. Thus, given that the peg is normally set at the level of the twelve-month ends before closing, a seller would often get a more favorable and reasonable peg if they run their business more like corporate buyers would, by not paying receivables overly quickly in the year before starting their sale process. Sellers would typically benefit from running their companies with adequate, but not excess, working capital in the year or more before negotiating the working capital peg.”
Jansen: “Based on decades of negotiating net working capital provisions, the best outcomes always occur when the net working capital composition and adjustment mechanics are clearly defined – ideally at the account level and within the letter of intent.”
What should buyers keep in mind to best navigate this portion of the deal?
Hanna: “The buyer should state their intended approach to working capital in their letter of intent (i.e. the average of the previous 12 months on a GAAP basis). The parties can always agree to adjust that approach during diligence.”
Kozik: “Be reasonable and don’t try to use the working capital adjustment as a way to knowingly grab value from the seller. Your goal should be to ensure that you have adequate working capital to comfortably operate the business. It should not be to try to get a seller to agree to a working capital structure that, if accepted, has you cheering and popping bottles of champagne.”
Emory: “The buyer doesn’t want the seller to change the way they have run the business in the past and unnecessarily run down the level of working capital leading up to a sale transaction. For example, the buyer wouldn’t want the seller to stop paying payables in the months before closing, leaving the new owner an unusually high stack of unpaid bills.”
Jansen: “Beyond historical analysis, acquirers also need to be mindful of the future working capital needs of the business, which can sometimes be dramatically different.”
