More than half of the 703 respondents to a spring survey of deal professionals by the Association for Corporate Growth and Thomson Reuters expected M&A transactions to increase during the second half of 2009.
But while optimism about M&A activity is increasing, deals remain highly sensitive to pricing. Because working capital true-ups may result in a significant purchase price adjustment, private equity executives, whether they are the buyer or seller, need to be more aware of working capital during the transaction process. Failure to do so may result in unpleasant surprises, and in this market where there are numerous impediments to closing deals, conducting proper due diligence on working capital is a proactive way to help move the deal forward and mitigate unfavorable outcomes.
The working capital true-up is the difference between actual working capital at closing and the target working capital, resulting in a dollar-for-dollar true-up. If actual working capital is higher than the target working capital, the seller receives additional proceeds. If actual working capital is less than the target working capital, the buyer is refunded part of the purchase price.
In an acquisition, there is an expectation that the seller must deliver a minimum level of working capital to keep the business running after closing. Waiting until just before closing to negotiate the target working capital amount, which is often a significant point in the transaction, can prove to be a costly mistake—and may later result in disputes between parties over the working capital true-up.
“Working capital is a meaningful issue and often the buyer or seller is likely to wind up paying more or receiving less than was their intention at closing,” said Dave Krasne, partner at private equity shop
“Dispute resolution and litigation are not only expensive, but [they] are lengthy processes—distracting management from their business as well as endangering the deal,” said Krasne. “It is important to understand the economic impact of the dispute and manage it accordingly.” Performing proper working capital due diligence ahead of time adequately protects both the buyer and seller in the purchase agreement.
The purchase agreement will stipulate how closing working capital should be calculated, but the buyer and seller often have differing opinions as to the methodology used in calculating closing working capital. The elements of working capital that require estimates—such as an allowances for doubtful accounts and excess and obsolete inventory, or a reserve for future warranty obligations—often give rise to disagreement between the parties due to the subjective nature of the calculations. That’s why it is imperative that the buyer and seller discuss the target working capital and the manner in which closing working capital is to be calculated prior to signing the purchase agreement. To help assure all differences are resolved before closing, accountants for both parties should also be included in these discussions.
There is somewhat of an expectation gap between the parties as to the amount of working capital that should be delivered at closing. Often, sellers expect additional proceeds as a result of the working capital true-up, while buyers anticipate a reduction of the purchase price. This is not the intent of the working capital true-up. “The working capital true-up is intended to provide the buyer with an adequate and minimum amount of working capital to keep the business running post-closing,” said Brian Boyle, senior managing director at investment bank McGladrey Capital Markets, in a phone interview. “In the current economic environment where a company is not performing at optimal levels, more cushion is required in working capital to fund the business. This is also true for companies experiencing rapid growth.”
Role Of Due Diligence
There are many variations as to how target working capital is established in the purchase agreement. Sometimes it is based on average working capital for the trailing three, six or 12 months prior to deal date, or it can be based on a recent date—such as the date when financial due diligence is performed. It is extremely important for both parties to perform due diligence before establishing the target working capital amount.
PE buyers spend a significant amount of time and resources on financial due diligence. Because many findings from financial due diligence are also applicable to working capital, PE executives are missing a valuable opportunity to leverage that information when it comes to setting the target working capital. Most of the common normalizing due diligence adjustments impacting the quality of earnings usually impact working capital.
Since the working capital true-up may be a significant portion of the total deal price—sometimes 10 to 20 percent—the seller should also perform appropriate due diligence in determining target working capital. The seller has internal knowledge that can be used during the deal negotiation process to help assure there is not a large discrepancy between actual and target working capital. In a situation where the seller is aware that working capital is cyclical or seasonal due to the underlying nature of the business, addressing this factor as part of the negotiation helps protect the seller.
Working Capital Pitfalls
1. Vague definition of working capital. Be specific when defining working capital in the purchase agreement. Most definitions of working capital are determined in accordance with U.S. Generally Accepted Accounting Principles (GAAP), unless it is a cross-border transaction where the standard may be International Financial Reporting Standards (IFRS). “This can be problematic when the target is a private company and has not historically prepared financial statements in accordance with GAAP”, said Ken Kolmin, partner with law firm Sonnenschein Nath & Rosenthal LLP, in a phone interview. While the parties may attempt to restate working capital in accordance with GAAP, more often than not, this results in misunderstandings that can lead to a dispute. To avoid this, the purchase agreement must be very specific in defining the methodology used to determine working capital at closing. Each party should have its accountant review the working capital definitions and computations, since accountants have the most knowledge of GAAP,” said Kolmin.
There can be some tricky elements when it comes to defining working capital. What if the agreement states closing working capital should be determined in accordance with U.S. GAAP in a manner consistent with past practices? There may be instances where past practices conflict with U.S. GAAP. For example, the seller reports consignment inventory at selling price, but to be in accordance with U.S. GAAP, it should be reported at cost. Which part of the definition prevails—U.S. GAAP or past practices? The definition in the agreement must specify which component prevails.
2. Purchase agreement doesn’t protect you. Because the buyer takes over the accounting function after closing, most agreements provide for the buyer to prepare the actual closing working capital. However, this can vary—especially if the seller remains in the business after closing and the buyer does not become actively involved in the day-to-day running of the business. Either way, make sure the agreement protects you. If you are the party that is reviewing the other party’s calculation, ensure the agreement provides sufficient time for you to review the calculation and allows you or your financial advisors adequate access to the underlying accounting records, supporting documentation and very importantly, the company’s personnel—so that you can interview the preparers of the closing working capital computation. Too often there are situations where the party is denied access to accounting personnel and the underlying supporting documentation.
3. Purchase agreement doesn’t provide for appropriate dispute resolution mechanisms. The dispute resolution mechanisms should provide for arbitration and mediation and avoid a trial by judge or jury. “Consideration should be given to resolving working capital disputes in a non-judicial setting, such as an arbitration or mediation process that includes the use of a third-party accounting professional familiar with M&A transactions,” says Kolmin. Make sure the agreement provides you with sufficient time to prepare for dispute resolution. Preparing for arbitration is complex, time-consuming and usually requires assistance from both your legal counsel and accountants. Leave yourself some cushion.
4. Working capital true-up and definitions are not applied to the purchase agreement as a whole. There should be consistency in the definition of working capital elements throughout the purchase agreement, as these items are not only referred to in the section dealing with working capital true-ups, but also other sections of the purchase agreement. What’s more, the purchase agreement should clearly state whether an item should be included in the working capital true-up or if it should be dealt with under a different section of the agreement, such as the indemnification provisions. For example, if you have agreed to increase a warranty reserve for the purposes of working capital, make sure the buyer is precluded from making the same or a similar claim in accordance with the indemnification provisions of the agreement.
5. Waiting until the last minute to negotiate the working capital target. Too much is at stake to wait until the end. Often, the provisions and definitions of working capital are incorporated into the purchase agreement as an afterthought. As a result, interested stakeholders—buyer, seller, investment bankers, attorneys and accountants—may not all be on the same page, leading to unexpected issues and unpleasant surprises.
“In my experience, there are typically five items that lead to post-closing disputes: indemnifications, warranty provisions, escrows, baskets—and working capital,” said Boyle of McGladrey Capital Markets. With adequate planning and proper due diligence, you can get it right the first time and avoid these common working capital pitfalls to help assure the deal closes in a timely manner and without issue.
William Spizman is a managing director with RSM McGladrey’s national Transaction Support Services practice. He specializes in transaction support and advisory services for private equity funds, private investors and business enterprises and can be reached at 312.634.4422 or email@example.com. Harold Perlman is a manager with RSM McGladrey’s national Transaction Support Services practice and has 10 years of professional experience working with private equity and venture capital firms. He can be reached at 312.634.4479 or firstname.lastname@example.org.