Don't let working capital kill the deal

Working capital discussions: Front and center in deal negotiations

Jul 15, 2020
Private equity

In today’s competitive market, deal-makers want to complete transactions quickly at the right valuation. To ensure this outcome, starting the working capital mechanism discussion at the onset of a transaction is more important than ever.

However, working capital negotiations can become very complicated when a company is being bought or sold because it’s not always so simple to agree on the right amount of working capital and the working capital definitions.

Typically, at the beginning of a deal, the letter of intent has some general language about the working capital so the buyer can feel comfortable going into the deal. It’s at the end of the deal that very precise working capital language comes into play. However, waiting until the end of the deal often creates undue issues that can impact the closing of a transaction.

A competitive market, like the one we’re experiencing,  tends to make it easier for sellers to walk away if a deal isn’t finalized quickly. Buyers and sellers often have very different viewpoints on what is the right amount of working capital, which could result in a killed deal. Unfortunately, it’s all too common for both parties to leave discussions about working capital levels until the deal gets close to a close. If a working capital agreement can’t be reached and the deal falls apart, it is a huge waste of time and money for all involved parties.

Having a deal die because of disagreement over working capital levels may be extreme, but not talking about the working capital mechanism early on can create other problems as well.

From the seller's perspective

A seller should consider the working capital mechanism prior to going to market.  Having a proposed working capital mechanism in place in advance to provide to potential buyers can avoid last minute disputes about how the calculation should be made. In drafting the purchase agreement, the seller should leave nothing open to interpretation. Ambiguity in working capital agreements generally allows the buyer to formulate an interpretation of the agreement. Sellers should carefully lay out the working capital definitions and the related accounting principles to avoid post-close surprises.

Additionally, sellers should be sure to consult with due diligence advisors. These advisors are skilled at reviewing the numbers and can help sellers analyze and decide on the right working capital numbers and language to include in the agreement. Sellers who don’t use an advisor are easy to spot as there are gaps in their agreements that give buyers the upper hand.

Factors to consider when establishing a working capital target include:

  • Is there seasonality in the business?
  • Is the business growing and will future working capital needs be different than historical?
  • What constitutes normal working capital for the industry?
  • What is working capital as a percentage of sales?
  • Is there any unusual or one-time transactions causing the company’s working capital to vary from normal levels?

From the buyer's perspective

Buyers want to get to the finish line and that often includes securing financing to close the deal. The credit markets have tightened and there’s no question that lenders are taking a closer look at which mergers and acquisitions transactions to finance. Having the right working capital language will help lenders get more comfortable with a deal and bring the buyer one step closer to closing. Receiving financing without the working capital agreement in place is nearly impossible because it becomes an additional purchase price consideration—a risk lenders aren’t willing to take today.

Buyers need to review working capital agreements carefully. It is beneficial to get ahead of any issues that may slow the deal from closing.

Factors buyers should consider when looking at working capital agreements:

  • Are there sufficient receivable or inventory reserves?
  • Do the numbers include accruals such as vacations, payroll, bonuses, warranty, sales allowances and medical claims?
  • Are cutoff issues on an interim basis accounted for?
  • Is the business and its working capital needs growing?

It’s important to note that working capital can vary from company to company, even in the same industry. For example, software companies can have negative working capital, given they are paid in advance in many cases. This is very different from other industries.

That said, it doesn’t change the fact that working capital is very important to the operation of a business. Time and time again, we see value lost from not putting in the appropriate level of time at the onset of a deal. Don’t let working capital agreements get in the way of your next deal closing.