For <$1M EBITDA deals, is A/R & inventory normally included or excluded?

June 10, 2022

by a searcher from University of Florida in Denver, CO, USA

Everyone I've spoken with has a different take on whether A/R and/or inventory is included in the asking price or not. Many deals I've looked at in this range seem to exclude the inventory from the asking price, but include the A/R.

I'm currently looking at a deal where both A/R and inventory are excluded from the asking price. Would love any insights others are having into this, and if this deal is outside of the norm, any best practices in discussing this with the broker/owner during negotiations.

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Reply by an intermediary
from Wake Forest University in Winston-Salem, NC, USA

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 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, if used. 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 18% included working capital, $1-$2M only 29%, $2-$5M only 39%, but in the $5-$50M 73% 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 acquire or 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 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.

Reply by an intermediary
from The University of Chicago in Chicago, IL, USA

1) Any arbitray criteria like size, type, AR/Inventory discount, etc. is non-productive. The origin of the confusion started decades back when a) databses primarily included B2C retail businesses that had no AR and lacked quality inventory records, and b) difficulty in collecting quality data.
2) WC is included in all PE deals regardless of size. How does that work? ALL PE DEALS ARE BASE DON ROI, NOT ON MULTIPLES. PE does look at multiple, but as a sanity check, not as a primary determinant.
3) My approach on all deals.
a) A buyer should calculate "Total Cost" (X) to acquire the business. X is "price" from buyer perspective. X should include any and all assets required to achieve the go-forward SDE/EBITDA. X should be financeable and meet buyer's expected ROE.
b) Seller's price (Y) colud be different than X if Y excludes all or some of WC. Typicall Y is less than X. If the deal is based on Y, then buyer should have financing lined up to fund the X-Y spread post-acquiaition.
c) If seller/broker cannot except Y, then buyer should walk.
4)) A buyer who does do pro-forma model, meaning only relies on market multiples, will not be able determine X. And, hence, will reduce their ability to convince seller/broker on X (including WC) or Y (excluding WC).
5) Market muliples are very helpful. But they are not a gospel even though firms like BVR go out of their way. And, even after all that the std. deviation is +2 (e.g. if average multiple is 5, then 2/3 of the transactions range from 3 to 7).
To calculate multiple, the databases need SDE/EBITA and Price. Look at the variations.
What is SDE/EBITDA? Is that adjusted or reported? Is that broker's adjusted number or that of buyer? Is that TTM or last FY or average of last few years or foreacsted?
What is Price? Does that include earn-out, non-compete, real estate, WC, seller salary, ec.?
6) The only way I know to overcome these issues is to use both the pro-forma and market multiple.

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