Can my deal have too much Working Capital?
April 15, 2021
by a searcher from IE Business School in Montreal, QC, Canada
Hi Everyone,
I am curious into how many deals go through with a value of working capital at closing. In one of my deals I have about 1/4 of the purchase price in working capital that will remain in the business at closing. I have been told this is not very common, what are your experiences? I know some might not discuss this until the end of closing a deal, but I thought it was important to get out in the open air so we are on the same page from day 1. Let me know!
from Wake Forest University in Winston-Salem, NC, USA
^redacted raises a very good point, the buyer is buying and borrowing the WC implicitly via the acquisition price or explicitly via a working capital loan -- and you don't want to unnecessarily borrow working capital that you don't need. But you definitely want to have it on the table for discussion (regardless of the amount) earlier than later.
Two good discussions threads on the topic:
https://www.searchfunder.com/post/why-working-capital-matters-in-your-search-fund-acquisition
https://www.searchfunder.com/post/how-to-get-brokers-sellers-to-understand-working-capital
As to the question of the size that is normal, the answer largely is -- it depends. It depends on the size of the transaction and the database that was used to come up with the multiples (SDE or EBITDA) as part of the valuation and on the industry and company trends (whether you are purchasing it or explicitly borrowing it in a WC permanent loan or LOC).
While there is no question that a buyer needs working capital on day 1, it turns out that only a minority of transactions in the <$5 million size include working capital in the purchase. The IBBA/M&A Source posts quarterly data that show the % of transactions that include working capital vs. exclude it. In summary, looking at the average for the last four quarters for deal sizes in the $500k-$1M range only 21% included working capital, $1-$2M only 24%, $2-$5M only 42%, but in the $5-$50M 71% included working capital. In the cases where it is not part of the purchase, it is usually provided by the acquisition lender in the form of a permanent working capital loan and possibly also a line of credit (this is usually right on their term sheet next to the acquisition loan).
It's important for buyers and sellers to know what perspective along the working capital continuum the company was valued and then offered at. That continuum being: (1) base company value + (2) other assets/liabilities (such as deferred revenues, customer deposits, payroll/vacation/bonus accruals, etc.) + (3) inventory + (4) AR/AP + (5) other = (6) aggregate company value.
Most transactions that buyers see on sites like BizBuySell or Axial are going to be a combination of 1+2+3, and exclude 4+5. In these transactions the buyer does not pay for the net value of AR/AP, instead, the seller keeps them and the buyer takes out a working capital loan along with the acquisition loan to cover future working capital (this is how many SBA loans are structured). Occasionally, the buyer will want the AR/AP for customer experience reasons, and will buy the net AR/AP dollar for dollar or close thereto.
The key is to make sure that when using a valuation multiple to come up with the asking/offer price that the comparables used are in sync with assets/liabilities being offered/requested. Each database handles the working capital differently, so the user has to know the inventory and net working capital rules before applying them to a transaction -- just like it would be a significant mistake to apply a multiple of SDE to EBITDA, it would be a significant mistake to use a multiple that excluded working capital and then use value derived from that multiple to represent a price that included it.
In short, here is how each of the major comps databases handles inventory and working capital:
-BizComps: specifically excludes inventory and AR/AP (you are getting values 1+2 (if entered)).
-PeerComps: includes normal inventory, excludes AR/AP and other working capital. You are getting value 1+2+3.
-DealStats (fka Pratt's Stats): Can include or exclude net working capital - this varies greatly by industry and data set pulled. The user must look at the asset allocation detail for the comps being used in order to determine where on the working capital continuum those particular comps are located and thus appropriately sync the derived value to the appropriate level of net working capital included.
from Georgetown University in Chicago, IL, USA
With regard to a peg, I don't ever specify how much a holdback would be but do include some language around the expectation for one for added clarity. The actual size of the working capital peg could vary a lot by business, and at first glance 1/4 of the purchase price seems like a lot for a peg (I could be misreading). Ultimately I'll determine that in diligence by looking at a) trailing twelve month NWC to set a "target" and b) understanding the usual fluctuations (i.e. normal NWC is 100k and it usually swings +/- 20k, so I'd probably set a holdback somewhere between 20-50k). The holdback should be enough to cover the shortfall so you don't have to go back to the Seller for any deficiencies - to the extent you're being upfront and communicating with sellers, I think this is the key. WC pegs are designed to be "no blood", not a cash/Purchase Price grab.
I'd also point out that based on the relative size and comfort level in the operations of the business (i.e. do I have confidence the Seller didn't just go off and stop paying the bills, selling or accelerating collections on all A/R?), you could be totally fine foregoing the concept all together.