What is working capital and why is it so heavily negotiated in M&A transactions? Justin Thomas from Cohen & Company joined us for a deep dive into working capital to discuss how it is calculated and how it impacts the sale of businesses.
1:03 - Working capital definition
2:57 - How does working capital affect purchase price?
6:12 - How does the market most commonly calculate working capital requirements?
7:40 - Is working capital affected by a business's seasonality?
9:19 - Example working capital calculation illustrating when it would positively or negatively impact purchase price
12:23 - What is a working capital collar?
13:46 - What items are most commonly miscategorized as working capital?
15:18 - What is the goal of a working capital adjustment?
17:18 - What is the most common reason for working capital adjustments?
18:56 - How is deferred revenue viewed from a working capital perspective?
hello and welcome to another episode of well-capitalized I'm your host Bobby Kingsbury managing director at MCM Capital Partners and today we have with me again Justin Thomas from Cohen & Company diving deep into a major topic with business owners and entrepreneurs in working capital so Justin thank you very much for taking the time yeah thanks for having me yeah and for the viewers who haven't watched one of our videos prior with you can you give a little bit of background on Cohen in yourself sure Justin Thomas I'm the partner in charge of our transactional services practice at Cohen company which is the group within the firm that specializes in performing due diligence for our clients going through a transaction either on the buy side or the sell side so with this topic it's come up even in in diligence videos from legal and bank and then some owner interviews and you know working capital kind of seems to be this this topic that maybe a lot of business owners don't understand or don't know how it would affect them so I think first can we just really define working capital and and what it is sure working capital in particular and how we think of it in a transaction is very very simply put just the net of your current assets and your current liabilities in the business all right so it's the it's the near term net calls on cash so that's why we don't include cash in that calculation but it's the things in the near future that are gonna convert to cash like your AR in your inventory and then the things that should be a draw on cash in the near future like your payables and accrued expenses and so it's just setting an understanding of kind of where the business is from a standpoint of kind of the net of those two items yeah and sometimes what we see in negotiation so we spell it out in a letter of intent to truly define exactly what what working capital is do you think that's important for a business owner and in their negotiations I do I think I actually think it's important and beneficial for both sides of the transaction to understand the nuances of exactly what we're going to call working capital for purposes of the transaction so I just give a general definition but ultimately when you get to the end of a transaction and you're defining working capital in a contract for purposes of how it may or may not affect your purchase price identifying specific accounts and balances that are going to be part of that measurement or not is very important so I think it's just a best practice for everybody to spell that out in as much detail as you can so again everybody's singing from the same hymnal when it goes when it comes time to close and so in talking about that a little further you know in in a contract then is it really so working capital what about indebtedness I need to find it indebtedness yeah you know maybe we take a step back and look at the whole concept and how it affects a sellers ultimate purchase price in cash they receive so obviously in a transaction the big number is the headline purchase price you know again for sake of argument just say it's 20 million dollars right and that's clearly what most people are focused on and what most of the due diligence process whether it be financial tax legal whatever is is structure around confirming but the the key point to keep in mind is that value so that that offer price is almost always defined as a what we call a cash free debt free price right so what that means that the business owner is I'm gonna give you 20 million dollars for this business you keep any of the cash that you've accumulated up until closing but you're also responsible for all the debt and that becomes important because as a seller realizes that they may be incentivized to play with their working capital to maximize the amount of cash they have on hand at closing right you know a a seller may do something like say hey I'm gonna give all my customers a 10% discount if they pay all their AR right now just to kind of get all that cash in the door so they can keep it and obviously as a buyer you don't want that to happen because then all of a sudden you know you've just paid twenty million dollars for a business and then you take it over and you you see you've got no receivables and so you've got no cash coming in the door for the first 30 days and you have cash outlays yeah so you need to fund another million dollars on top of the twenty million dollars you just you just spent so because of that dynamic of the deal being cash redead free over time again it's become just accepted in the market that will also have a target working capital so that ultimately is in place to make sure that nothing irregular happens worth with the working capital balances between the time of initial negotiation on price and the closing so the way that is that's done is to come to an agreement between buyer and seller and again all of this is an agreement that evolved over the course of the transaction and is codified in the purchase agreement so come to an agreement over what the right level of working capital to be in the business that closing is right so that that means hey I as the buyer you as the seller are both comfortable that with the value we've stated it being cash free dead free if we have about this much working capital in the business everybody thinks it's a good deal if when we close there's more than that working capital left in the business the owner generally keeps that difference if there's less the owner receives less cash a closed to make up for that difference and it's all the way just kind of keep connected the value of the headline price the concept of the cash free debt-free and the working capital mechanism being another lever to make sure that you know the cash free debt free nature of the transaction you know is it taken advantage of by either side right and then as we get into negotiations and usually in the letter of intent we are not necessarily defining a number but we're looking at you know the trailing 12-month average nine month average or six month average you know what what's market to today yeah it varies I think the thing we see most often is a 12 month average and for if you're a steady-state business you know you obviously probably have some growth in the business but if it's a normal level of growth I think the thing we would generally see as a 12-month average of those balances now if you're in a very high-growth type of business where you know you would expect the working capital needs of the business to be accelerating just because sales are growing so fast you might look at a shorter term like say the last three months or six months because that's just gonna be more representative of what the business is going to be at closing how does that then affect I was working capital affected by a seasonal business you know we owned the you know a garage-door part Smith manufactured there pretty steady state but in generally in September October November they see a spike in business specifically because people are getting ready for for the winter we own a company in Arizona that manufactures wrought iron security doors an entry doors and in Arizona the slow season is in the summer because it's so hot so I you know how do seasonal businesses get around the working cabin yeah so there's there's several ways I think that we've seen people handle those types of businesses you know one way is rather than use an average method you might say okay we know there are other certain metrics at play again given the anticipated timing of closing that would say okay if I'm going to close in the summer month I know that then generally my working capital is lower so to set a target at a very high level is probably unfair to the business owner because that's not what would normally be there at that time conversely if you were to close in the busy season to have an abnormally low working capital target and say well I'm gonna pay you just because we closed at your busy season doesn't really make a lot of sense either so sometimes you can use other metrics like well sometimes the working capital is relatively consistent as a percent of sales you know so you can look forward to the forecast sales for the three months leading up to closing and use a formula like that to come to a target it doesn't always have to be a historical average so there's other things that can be more indicative of the business when it's actually going to close the verses in average and you know honestly sometimes or other if if you do have a seasonal business folks will still go with a an average from time to time and and just kind of roll the dice on when it closes and who benefits and who doesn't right and we had talked about this a little bit or through some some of your other answers but what what I want to focus on for business owners to is ultimately how does working capital affect purchase price at the end of the day yeah and maybe that's helpful to go through an example you know and I think we'll have a have a graphic up on the video but you know I assume a company is now say you're a manufacturing company mm-hmm right so you know as we think about the working capital the primary components are going to be your accounts receivable your inventory balances you know maybe you've got some prepaids those are usually smaller numbers and then you've got accounts payable and you've got your accrued expenses so those are the things that are going to make up the components of working capital so say at the table using an average and over the 12-month average the net of all those numbers is a hundred thousand dollars and we come to to the closing and generally what happens is you know you come to the closing date then you make an estimate and you know nobody closes their books perfectly on a certain date so you're usually given time to actually close your books and and define what the real working capital is so we'll come back thirty sixty whatever days later and ultimately we find maybe you had a situation where right before closing you had a really big sale so that would maybe decrease your inventory because you've just shipped a bunch of product but you're also getting margin on that product so your AR has gone up more so all else being equal with that one big transaction right before closing that would increase your working capital say to one hundred and ten thousand dollars so in that situation and whatever the purge price was that additional $10,000 would go to the seller and you know that that feels right in some way Bobby right because hey I've just made this big sale and I'm not gonna get any of that cash but I get some benefit of it through the working capital now you know take the opposite end of the spectrum you could have a situation where again just based on timing of clothes maybe the closing date was a day or two before you've done your check run for that that week or every other week however often you do it and just because of that your accounts payable are just much higher than they normally are so in that situation you may have a close where the working capital is say ninety thousand dollars and again that ten thousand dollar difference would come off the payment to the seller and again that feels right because you get at the end of the day you as the buyer would inherit just a higher level of AP then it should be there just because of that that timing yeah and you know at the end of the day so working capital can possibly affect you know so you can be getting more money yep depending on the situation the agreed upon number or you could be writing a check because the working capital was not sufficient enough to continue to operate the business post transaction yep so but there's also something you know for the business owners at home is is there's a working capital collar you know and how does that come into play can you define that and tell us that sure that's another it's another popular mechanism right you know because again the examples I gave before are what we call a dollar for dollar type of adjustment where again if it was a target of $100,000 and we closed and the actual working capital closing were one hundred thousand and one dollars there would be a true up between the parties now most people don't want to go through that right so they may put what we call a collar around it to say okay we think there should be a hundred thousand dollars of working capital but if there's between ninety five thousand and a hundred and five thousand economically that's still the same deal we were thinking of and there's no need to write a check back and forth so that can help in the ultimate negotiation of the target again it's not tied to a specific number just because it gives both sides a little bit of a flux on either end because like you're never going to be able to nail down an exact working capital number at any period of time for any number of reasons so it's something that allows you to again have some have some flux in there not necessarily have to fight over every last dollar but still gets everybody economically the deal that they're hoping to get one last question is it relates to work couples it's going back a little bit in terms of definition and what's included there's been times where we've seen a seller try to include a potential tax refund into into working capital or some other assets you know that what are some of the more common ones that you see being placed that you know certainly don't fit in in the definition yeah so I think when we think about working capital in terms of this mechanism it should really be just the recurring assets liabilities of the business there are other places within the purchase agreement contract where a where a seller can make sure that they get paid for things like a tax refund right one hasn't come through yet there are other places within the contract where you could make sure that they get the benefit of that you know putting that into the working capital mechanism isn't always the best thing because just muddies the water on what it's supposed to be which is a really just a normalization the you know puts and takes on cash you know your current assets and your current liabilities so that's really the goal and so I would I would just urge people to you know if you have other items like that that you just deal with it and the way outside of working capital so the best you know to simplify the working capital calculation you know dumb it down to exactly what it entails yeah and then if there is something else put in other areas of of the person's to agreement or find ways to to get compensated or you know vice versa right for that I'd agree is there anything else you know from your experience maybe that we didn't cover from a working capital standpoint that you might want to let business owners know or to think of you know I would just say that you know understanding what this is and that it does have it could have an impact on your ultimate purchase price is important so give it some authority owner beforehand yeah you know and the goal everybody's goal should be that this results in no change Yeah right you know nobody wants to make or lose any real value because of the working capital adjustment the whole idea of it is just to have a fair transaction that lines up the economics that everybody agreed to so I you know hopefully everybody can avoid looking at it as a you know somebody's trying to grab a couple extra dollars from me ultimately it's just trying to make sure that the transaction is ultimately structured with the economics everybody originally wanted so but as a business owner you're still going to have to be cognizant of you know what is in that number and what is in that calculation from an account by account perspective and and the fact that it might impact you at the end of the day and I think one of the places we see this for business owners and a lower middle market company is they may not update their balance sheet accounts every month so you may for very good reason yeah so for very good reason you may not update your payroll accrual or other items other than at year-end because from month to month it doesn't really make a difference to you you're paying these things cash but the changes in those balances over time could have some impact on on what you're ultimately agreeing to as the target for working capital so just be cognizant of those items and you know make sure you're factoring that in when you're ultimately agreeing to what a target is going to be for working capital and one last question is does tail off of that then it's in your experience is it the you know accruals or what what's the been the biggest reason for an adjustment is the inventory what what generally is is the biggest reason that they want to make sure that they button up yeah two things one is one is accruals particularly you know maybe for things like a bonus if you know if you're closing near year-end you know you're getting to a time where maybe your employees have earned a bonus but you haven't paid it yet so that's that's another thing on timing is just certain of those liabilities can be heavily weighted towards one period or another and then the other the other item is inventory you know if we ultimately come to a spot where the final inventory balance and closing is going to be term and determined based on a physical inventory which we would always suggest is the route to go and as you close a transaction you should take a physical inventory particularly for a manufacturing company may not be as relevant for a service or other type business but for a manufacturing company so any differences that may exist between your records between your books and what's actually in your warehouse identifying that you know really well before you get to that point would be really helpful for everybody so you can properly adjust the mechanism to compensate for or hey maybe a difference that's been there for a long time but you just never true up on your books yeah which again is hopefully something that comes up during the diligence process yeah and then the last thing that really causes a you know a discussion we put it that way is has to do with deferred revenue so anytime you as a business are taking cash from your customers up front and then delivering a product or service at a later time that can become a difficult thing to deal with in the working capital because in reality when you look at that situation what you've done is you know you've taken a loan from your customer yeah so you know as we think about that ultimately that's really something that's more often than not thought of as debt yeah not working capital it's you know rather than take a loan from the bank you've had your customer pay you up front to finance something that you still have to deliver so you know we've seen it go both ways in the ultimate definition that go into the contracts of the deals we worked on but it's definitely something to think about in terms of pay that cash you've already received is that something that we call debt in the transaction or something that goes into the calculation of working capital yeah great well thank you Justin I really appreciate I think this is gonna be very beneficial for a lot of business owners this is again just a very salient topic for for a lot of them as it affects ultimately their their bottom line that's right yeah thanks Jeff right thanks thank you for taking the time to watch another episode of well-capitalized please subscribe to our channel below if you have any additional questions please leave them in the comments section thank you