In the structured process of buying and selling companies, an extremely important definition, although often misunderstood by those with little experience in M&A negotiations, relates to determining the normal level of working capital required by the company on the closing date of the transaction. Sellers and buyers are directly influenced by this determination and frustrations in the process tend to emerge whenever there is an inadequate definition of this level, when there were no initial discussions in this sense or even when there is no proper understanding of this concept.
But after all, what is working capital and what is its influence on price perception?
The net working capital is the difference between current assets and current liabilities with operational nature. Considering the proper application of accounting rules, this metric is an important reference of the short-term balance sheet position (usually characterized by an excess of assets in relation to liabilities which represents “working capital requirements”) that is demanded for the normal business operation.
This is an important metric for the seller since the excess cash to be withdrawn at closing (most transactions are analyzed on a cash free and debt free basis) is influenced by internal policies related to inventory, accounts receivable, accounts payable, etc., which determine the net working capital metric for the business. In other words, if the excess cash demanded by the seller has been reduced (or increased) by a policy or decision that has raised (or reduced) net working capital relative to normal levels, the net working capital adjustment should compensate the deficiency (or the excess) of cash.
The same rationale is equally important for the buyer. Imagine that the buyer takes over the business on a certain date with less net working capital than it would require at normal operating levels, thus generating an immediate deficit in liquidity after closing. Such situation, when determining the purchase price, was not expected by the buyer and therefore any contribution he makes to circumvent the situation and normalize the net working capital position is generally understood as a price adjustment.
The adjustment procedure and the rules of definition and determination of net working capital are defined in the purchase agreement and must aim at a fair and balanced situation for both sides.
Considering that in transactions for the purchase and sale of companies, both the amounts of debt and the excess of cash are generally treated in a specific way (with discount and increase in the price, respectively), the working capital analysis tends to be the result of the application of this scheme (the terms used may vary):
– Total Current Assets (-) Total Current Liabilities = Gross Working Capital
– Gross Working Capital (-) Excess cash (+) Debts = Net Working Capital
– Net Working Capital (+/-) Standardization Adjustments = Normalized Net Working Capital
Since the sequence for identifying both gross working capital and net working capital is quite straightforward – understanding the balance sheet structure is enough to find the corresponding balances at a given date – the normalized analysis of the net working capital is both the most important and the most complex point of this discussion, and is generally the subject of specific schedules in the purchase agreement. Knowing the operating history, the seasonality of revenue and the consistency of the company’s applicable accounting criteria is also critical to an adequate estimate that seeks the most balanced net working capital position possible.
To better address the issue, we will contextualize the subject with data from a generic transaction that has been closed based with the Enterprise Value (market value of equity stake plus debt and minus excess cash) under the following conditions:
Enterprise Value= R$ 50 million
(-) Debt = R$ 10 million (value determined at closing).
(+) Excess Cash = R$ 5 million (value determined at closing).
Equity Value (R$) = R$ 45 million
Note: Transaction contemplated with normal level of net working capital, estimated for the company at R$ 15 million.
Ideally, the amount of R$ 45 million will be paid by the buyer to the seller. However, this will effectively take place only if the net working capital is compatible with the normal level agreed between the parties. This is because if the buyer takes over the operation and finds a lower working capital position than the one expected, it will need to inject cash into the acquired company to guarantee the continuity of the operation, a circumstance not foreseen when setting the price. Therefore, the buyer will deduct from the seller (the form varies per the terms of the agreement) the difference between the amount effectively calculated and the previously defined R$ 15 million. Following the same concept, if the buyer has received the company with excess net working capital, it must reimburse the sellers as to the surplus value effectively found in the closing balance sheet.