The “Working Capital Adjustment” in Mergers & Acquisitions !

The “Working Capital Adjustment” in Mergers & Acquisitions !

Author: J.J.P. (Joris) Kersten, MSc RAB

Kersten Corporate Finance @ Uden/ The Netherlands

Saturday February 27th 2021

Source used - book: Crushing it as a corporate buyer in the middle market (2020). Kevin Tomossonie. Rock Center Financial Partners, New York.

Introduction Kersten CF

Kersten Corporate Finance is an independent M&A consulting firm in The Netherlands.

Deal segment: Middle sized and SME companies. So companies with an Enterprise Value (EV) of in between 2 million euro and 50 million euro @ The Netherlands and Benelux.

Activities:

1.    Selling companies;

2.    Buying companies;

3.    Business Valuation & Financial Modelling;

4.    Financing of acquisitions with bank loans and/ or private equity firms;

5.    Buy & Build strategies for strategic buyers and private equity;

6.    Searching & selecting acquisition targets;

7.    Finding multiples for precedent M&A transactions in a certain field.

Website M&A consulting: www.kerstencf.nl

Website M&A training: www.joriskersten.nl

M&A training:

·      Business Valuation & Deal Structuring – 6 day training – 7 until 13 April 2021 – Location: Hotel van der Valk Uden/ The Netherlands – Also online available on live stream. 29 PE points for Registered Valuators (RV) from NIRV;

·      Business Valuation & Deal Structuring – 6 day training – 29 September until 5 October 2021 – Location: Crown Plaza Hotel Amsterdam South – Also online available on live stream. 29 PE points for Registered Valuators (RV) from NIRV.

In addition, Joris provides valuation training all over the globe on (bulge bracket) investment banks and universities in: New York, London, Hong Kong, Singapore, Dubai, Saudi Arabia, Kuwait, Mongolia, Surinam and Peru.

130 references on M&A training: https://www.joriskersten.nl/nl/reviews

Introduction

Within this sequence of blogs I have written two already:

1.    Mergers & Acquisitions done on a “cash & debt free” basis (February 13th 2021):

https://www.dhirubhai.net/pulse/mergers-acquisitions-done-cash-debt-free-basis-kersten-msc-bsc-rab/

2.    Mergers & Acquisitions and the “net debt adjustment” (February 14th 2021):

https://www.dhirubhai.net/pulse/mergers-acquisitions-net-debt-adjustment-joris-kersten-msc-bsc-rab/

And in this blog of today I will talk about the “working capital adjustment” in Mergers & Acquisitions (M&A) !

Working capital

Working capital is a combination of short term assets and liabilities that a business creates as it does its day to day business.

Short term assets are assets like for example:

·      Accounts receivables from customers;

·      Inventories;

·      Prepaid expenses for things like rent and software licences;

And short term liabilities are for example:

·      Accounts payables to suppliers;

·      Accrued payroll;

·      And other accrued (operational) expenses that eventually need to get paid.

And this working capital is there every day and cannot be ignored, so it is just part of a business.

(Kevin Tomossonie, 2020)

Working capital in M&A

In M&A the working capital is normally calculated by taking current assets (excluding cash) minus current liabilities (excluding debt).

And the net of the two is the “net working capital”.

When for example a business has a normal net working capital level of around 5 million euro, it is expected that net working capital will be around 5 million euro around closing an M&A deal.

(Kevin Tomossonie, 2020)

Working capital adjustment

But as we know, working capital can fluctuate.

So buyer and seller in an M&A deal agree that the purchase price of a company (enterprise value/ EV) will be adjusted by a "normal level of working capital" to get to equity value (the price of the shares).

And this normal level of working capital is called the “working capital target” of a deal, and this number is used for the involved calculation.

For example, when the target working capital is 5 million euro, and when the real working capital level at closing is 6 million euro, then the purchase price will be INCREASED with 1 million (6 – 5 = 1 million “too much” working capital at closing).

And when the real level of working capital would be 4 million at closing, then the working capital at closing would be 1 million “too low” (4 in realtime – 5 on average = -1), so the purchase price will then be DECREASED with 1 million.

(Kevin Tomossonie, 2020)

Issues with working capital in M&A

Working capital adjustments in M&A serve two purposes:

1.    It protects the buyer that a seller will squeeze out cash from the business by decreasing its working capital (since this will be adjusted anyway with the purchase price);

2.    It realises that the seller will continue to invest in working capital in the business, even when they are selling, since adjustments for working capital on the purchase price will be made anyway.

The only problem is: How to set a “target working capital” ?!

Well, this needs to be set by analysis, judgement and negotiations.

And this will be the topic of my next blog: Setting working capital targets !

And in the blog after that I will talk about how deals are actually technically done.

And here in The Netherlands this is mostly done with a “locked box” mechanism. So there is more to come, stay tuned!

(Kevin Tomossonie, 2020)

Source used - book: Crushing it as a corporate buyer in the middle market (2020). Kevin Tomossonie. Rock Center Financial Partners, New York.

In the following blogs on this topic I will talk about:

·      Working capital targets;

·      Locked box mechanism.