We're getting close to signing a LOI for my manufacturing biz. Buyer's term sheet includes a working capital adjustment at closing. Is this pretty standard now? I've heard of it but never gone through an actual sale before. Can anyone explain how it works in practical terms without a textbook answer?
M&A deal terms
Working capital adjustments at closing
yes, absolutely standard. The idea is you deliver a normalized level of working capital at closing so the buyer doesn't get a surprise cash crunch right after. Make sure your target WC is based on a trailing 12-month average, not some hypothetical nonsense.
It's standard but also where deals go to die.The purchase price is often stated as 'enterprise value' and then adjusted up or down based on actual WC at close compared to a target. If your AR is messy, get ready for arguments.
Huge argument potential. Ask for a sample calculation and an example of a typical WC schedule before you sign anything. Also make sure the definition of 'current liabilities' excludes debt and transaction expenses. Sometimes buyers try to sneak those in and call it a negotiation
But what if the buyer wants to include all cash and exclude all debt? That changes the picture entirely.
Oh great, another WC adjustment thread. Grab your popcorn.
Ignore the popcorn guy. Here's the practical version: Target WC is typically a dollar amount based on a historical average. At closing, you estimate actual WC on a draft closing statement. Then 60-90 days later you do a 'true-up', and settle the difference. If actual is higher than target, buyer owes you. Lower, and you owe buyer. Simple in theory, brutal in practice if you don't have clean books.
Make sure the working capital definition includes only the normal operating assets and liabilities. Exclude cash, debt, taxes, capex, and anything unusual. Otherwise you're going to have a very fun argument with a buyer who suddenly decides a fully remodeled showroom is 'working capital.'
One more thing: whoever prepares the first draft usually has the advantage. If you have a strong CPA, you might want them to prepare the target WC schedule before the buyebr sends their version. Saves a lot of grief.
What's a typical peg? Like 10% of revenue? 15%?
There's no standard percentage. It depends on your industry and how you run the business. For a manufacturer, it could be more. Just don't let the buyer set a target WC so low that it's basically a built-in price cut. I've seen that happen
Also, watch out if the buyer asks for a 'normalized' WC that excludes seasonality. Your business might have a natural high inventory period. If they want a flat target based on an average, that's fine, but you need to flor it so you don't get punished for timing.
I’d also get a collar or a dead band. Small differences (say within $25k) just get ignored. Otherwise you spend $10k in accounting fees to argue over $5k. Seen it.
Above is good advice.And make sure the definition of 'indebtedness' is ironclad. Some buyers try to include things like deferred revenue or customer deposits as debt, which then also hits working capital. Double-dip nonsense.
I can't believe nobody's mentioned the best part: the post-closing dispute resolution. Enjoy paying lawyers to fight over a $12,000 difference.