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As a transaction advisor, one of the most difficult concepts to explain to an own/seller is the calculation and negotiation of the working capital target or peg.
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 explore the critical act of calculating and negotiating the peg in the transaction process.
The starting point for the calculation of the peg is the accounting-based working capital calculation as adjusted for specific transaction-related impacts, such as the elimination of cash, current portion of funded debt, owner payables, etc. Typically, it is important to review the calculation on a month-over-month trailing 12-month basis, starting with the most recent month-end close and looking backward for a period of 12-18 months. From a seller’s perspective, anomalies should be identified, eliminated or normalized, inclusive of one-time transactions, unusual terms or conditions related to receivables/payables that will not be applicable to the buyer post-sale, etc.
Also, it is crucial to examine the uniform application of the seller’s accounting principles over this period because changes can potentially impact the working capital calculation. A rolling 12-month average is then calculated so that trends can be identified. Peaks or valleys may indicate that additional normalization is warranted or that the results are from normal seasonal flow, industry trends or business growth. Regardless, further analysis may be warranted. Historical trends, as adjusted for the above, will create a basis for the establishment of the peg.
Once the peg is established, the parties will include the definition of Transaction Working Capital and the peg amount in the definitive purchase agreement. A careful review of these provisions is warranted to ensure that the document adequately reflects the understanding between the parties. The clearer and more detailed the definition of Transaction Working Capital is and the items included or excluded in the calculation, the less likely a dispute or litigation will arise post-transaction.
From a deal perspective, it is advantageous for the seller to take the lead in establishing and negotiating the peg. Buyers will typically engage a firm to perform a Quality of Earnings analysis that will include an analysis of working capital. As is the case with many buy-side advisors, they will be highly incentivized to demonstrate value by identifying and driving a higher peg. Compromise will frequently be required as the two sides work together to reach an agreement on the peg amount.
After the peg is determined, changes in Transaction Working Capital relative to the peg frequently result in a timing difference versus a permanent impact on purchase price. For instance, an increase in sales volume may create higher than anticipated accounts receivable. This could result in working capital at close exceeding the peg and an increase to the amount paid at closing because the seller is delivering working capital in excess of the peg amount. While the buyer may be impacted at close, as the receivables are paid and cash is received post-closing, the buyer is placed in a cash-neutral position relative to the additional amount paid.
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:
For the complete series, download the Deal Me In: The Importance of Working Capital Management in a Transaction whitepaper.
The Schneider Downs Transaction Advisory Services and Corporate Finance Teams provide the strategy, guidance and services organizations need to create value through all stages of a transaction, including due diligence and quality of earnings, mergers and acquisitions, exit and succession planning, capital raising and corporate finance.
Schneider Downs Corporate Finance, LP is a registered broker/dealer. Member FINRA/SIPC.