What is working capital and how can it impact a sale transaction?
Beyond the pure accounting definition of working capital, the working capital target or “peg” and associated true-ups can be confusing. Mostly, this is due to the inherent complexities that arise and that determining a peg is often more of an art than a science.
This article will help you understand what working capital is and why it matters in a transaction.
What Exactly is Working Capital?
From an accounting perspective, working capital is defined as current assets minus current liabilities, as derived from a company’s balance sheet. Fundamental to this calculation is the appropriate classification of assets and liabilities as long-term or current. Perhaps the easiest way to think about this is that a current asset or current liability is expected to convert to cash or result in a cash outlay over the course of 12 months from the balance sheet date. Accounts receivable and accounts payable; for example, are two common types of current assets and liabilities that would be expected to impact cash within a 12-month period. Items such as rent deposits need to be examined to determine whether a current classification is indeed appropriate.
The accounting definition; however, is just the starting point for calculating working capital in a transaction. Inherent in most deals that involve the sale of an owner’s equity interest, is that the transaction is on a cash-free, debt-free basis. Thus, cash and funded debt are excluded from the calculation of working capital. That is, the buyer does not assume the seller’s funded debt or keep any of the cash. Other items that are commonly excluded from the transaction-based calculation of working capital (the “Transaction Working Capital”) include any federal or state income taxes payable or receivable, amounts due the owner/seller, interest payable, amounts payable resulting from transaction-related costs or bonuses, and related party transactions or transactions which are not at arm’s length.
One of the more complicated areas that can arise for technology companies is the treatment of deferred revenue. For subscription-based businesses, cash is typically received in advance of the obligation to perform a service. Although the seller will receive the cash, the buyer is nevertheless responsible for funding the downstream obligation created by the subscription agreement.
Buyers will frequently seek to have deferred revenue carved out of the working capital calculation and treated as debt. While it can be advantageous for the seller to treat deferred revenue as a component of working capital, compromise is often warranted. Ideally, whether treated as a component of working capital or carved out as debt (and paid for by the seller as a reduction of purchase price), the seller should seek to have the obligation reflect the actual cost of the future obligation as this may be a fraction of the deferred revenue balance.
Why Does Working Capital Matter?
A seller is typically expected to provide a buyer with a “normalized” amount of working capital as of the closing date of a transaction. This is important to the buyer as the working capital left by the seller will be used to support the operations of the business post-close. If a buyer does not have an adequate amount of net working capital, short-term needs must be identified and funded. While it is not unusual for a buyer to infuse some amount of cash into the business post-close, an inadequate level of working capital can effectively result in an additional cost for the buyer.
This article is part of a series exploring the importance of working capital in a sale transaction. Additional articles include:
For the complete series, download the Deal Me In: The Importance of Working Capital Management in a Transaction whitepaper.
About SD Capital
SD Capital is a premier, full-service, value advisory and investment banking practice that assists middle-market companies in creating and maximizing business value. We provide strategic evaluation and execution of various downstream sales and monetization pathways. With decades of combined executive experience running, owning and advising private companies our team is uniquely positioned to guide owners through the complex process of growing and selling their companies.
Learn more at www.sdcapital.com or contact the team directly at [email protected].
Schneider Downs Capital LLC is a subsidiary of Schneider Downs & Co., Inc.
