March 2, 2018

Negotiating Working Capital Adjustments

Working capital adjustments are often some of the most heavily negotiated provisions of private company acquisition agreements. This excerpt from a recent FEI blog discusses some of factors that parties should take into account in developing their negotiating positions:

– First, analyze the actual historical monthly working capital; start with the trailing twelve months from the most recent month-end closing. Because most transactions are “Cash Free Debt Free”, cash and funded debt (interest bearing debt) are excluded from the working capital calculation.

– If you are on the sell-side of the transaction, look for opportunities to normalize the historical numbers on the balance sheet giving consideration to what the buyer is likely to experience post-closing and accounting for income statement normalizations. For example, consider excluding certain one-time extended accounts receivable balances if those terms will not exist for the buyer.

– If there are extended (or stretched) accounts payable, the amounts of these accounts may look like funded debt to the buyer and become the responsibility of the seller at closing …resulting in reduced cash to the seller. A seller can defend against this claim if the vendor agrees to provide those terms extended terms permanently.

– Keep in mind that customer deposits for future work are usually carved-out as an exception to the Cash Free Debt Free concept …the seller is expected to leave cash in the business to cover those amounts. A possible solution to minimize the impact to the Seller of this cash exception, is to look for opportunities to reduce the deposit amounts where there may be work in process that has occurred but not been recognized… and then making the recognition.

– For software or subscription based businesses, start the analysis by excluding deferred revenue. A compromise in the negotiation is to accrue the estimated cost of services in the future needed to support the operational commitment created by having those deferred amounts.

– There are three time-based variables that can impact the working capital calculation in some deals: (a) the period used for analyzing and determining the working capital target, (b) the number of days in aging accounts receivable in which the buyer will not recognize the value of invoices, and (c) the number of days in accounts payable that the buyer will consider those invoices as effectively funded debt. For each of these, analyze the numbers in comparison to both historical norms and industry norms to determine opportunities to create an argument for exceptions that will reduce the required level of working capital.

John Jenkins