As a transaction advisor, one of the most difficult concepts to explain to an owner/seller is the close and settle-up considerations of a purchase agreement.
Close and Settle-up
In addition to the peg amount and definition of Transaction Working Capital, the purchase agreement will contain a mechanism to assess the impact of working capital at close and the ultimate settle-up of the working capital balance.
Typically, to facilitate the close, a good faith estimate of Transaction Working Capital as of the close date is calculated by the seller, and the difference between the peg and estimate is treated as an adjustment of the purchase price. If the estimated Transaction Working Capital exceeds the peg, the excess is treated as additional purchase price. Conversely, if the estimated Transaction Working Capital is less than the peg, the deficit is treated as a reduction in purchase price.
Since the amount of Transaction Working Capital at the close is based on an estimate, it is standard practice for the purchase agreement to include a mechanism for the true-up of the balance once the amount of Transaction Working Capital can be definitively calculated. Some 60 or 90 days post-close, the buyer will prepare and provide the seller with a calculation of the actual Transaction Working Capital as of the close date.
The seller will have an opportunity to review the calculation and assuming it is in agreement, the delta between the amount of estimated Transaction Working Capital as of the close date and the actual Transaction Working Capital is paid to either the buyer or seller (paid to the seller if actual is greater than the estimate and paid to the buyer if actual is less than the estimate). Frequently, an escrow will be carved out of the purchase price to protect the buyer if the actual Transaction Working Capital turns out to be less than the amount estimated at closing.
As an alternative to, or in order to, limit the amount of escrow, a buyer and seller may negotiate a working capital collar. A working capital collar establishes a floor and ceiling amount. The floor represents the minimum amount that the seller is to deliver at close, and the ceiling is the maximum amount. This can be useful to facilitate the settle-up process. If the actual amount of Transaction Working Capital falls within the collar, no amount is due to the buyer or seller, and the escrow is released.
The Benefits of Working Capital Management
Effective working capital management can result in tangible benefits at the time of the sale. By promoting working capital management and improving the cash conversion cycle, the working capital peg can be minimized (and cash maximized), while also creating efficiencies within the business. Typical strategies include improving collections, payables and inventory management. Since trending in establishing the peg is a key consideration, effective working capital management should be initiated well in advance of the sale of the business. This exercise will also create additional value in the business that can be realized upon the sale.
This article is part of a series exploring the importance of working capital in a sale transaction. Additional articles include:
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.