Working capital peg in a deal - How does it work?

September 24, 2020

by a searcher in San Francisco, CA, USA

I would like to understand the basics of working capital peg in a deal and how it works once we peg the amount. I’m adding a simple example below so that someone can help me understand. Consider a fictitious company XYZ …

TTM Revenue - $10M TTM EBITDA - $2.5M TTM Current assets (A/R excluding cash) - $2M TTM Current liabilities (A/P and other current liabilities) - $1M

Now, working capital is current assets - current liabilities = $1M per above example.

Assume valuation at 4x multiple - $10M. Given this simplistic example, my questions below …

1- If we peg back the $1M working capital we only pay the seller $9M and not $10M? Is this how we deal with working capital? 2- If we pay only the $9M, then does the seller gets to collect the accounts receivable ($2M in above example) and buyer does not get it? 3- If #2 is not accurate then does buyer deduct $1M as working capital peg AND keep the A/R as well?

Which is the norm here - #2 or #3? Can anyone share a link explaining that as the norm (I looked around but I cannot find a definitive source)?

PS: I also saw a couple of prior posts here about getting brokers to understand working capital but adding a new post to this topic since my question seems even more fundamental.

Reply by a searcher
in Chicago, IL, USA

Your baseline assumption is that the business you are acquiring will have sufficient NWC to operate as a going concern day 1 post close. You set a PEG that is mutually agreed on by both buyer and seller and measure the amount of NWC delivered at close to the PEG. If the seller delivers more than the PEG, the buyer owes the difference. If the seller delivers less than the PEG, it is effectively a reduction to the closing purchase price (net-net you are indifferent because while your purchase price at close may be lower, you will have to "fund" the business post close by accumulating additional NWC).

It should only impact valuation from the perspective of over/under delivery at close vs the PEG. Your multiple of earnings implicitly assumes the business is delivered with the appropriate amount of NWC. Ultimately crafty buyers/sellers can make a "grab" for additional value by arguing excess NWC or setting the PEG in their favor. However, the intent is that the seller doesn't do anything nefarious with the working capital between signing and closing (i.e. accelerate all the receivables so you get less than you anticipated etc.)

Reply by a professional
from Villanova University in New York, NY, USA

NWC can be very complicated! I do quality of earnings/financial due diligence and deal with this concept regularly.
Most transactions are structured so that the purchase price/enterprise value is inclusive of NWC. In your example above, purchase price is $10M and that includes $1M of NWC. At close, you assume the current assets and current liabilities.
If Seller wants to keep NWC, or you don't want to assume it (for any number of reasons), you would only pay $9M ($1M PP deduct) b/c Seller keeps it and turns it into cash. Seller gets the $9M PP and $1M NWC for total enterprise value of $10M.
I'd be happy to discuss further. My email is redacted

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