Protecting deal value: working-capital hurdles in M&A transactions
June 2013 | SPECIAL REPORT: MERGERS & ACQUISITIONS
Financier Worldwide Magazine
In most M&A transactions, the parties arrive at the purchase price by multiplying the target company’s earnings before interest, taxes, depreciation, and amortisation (EBITDA) by an agreed-upon multiple. Before a deal closes, however, a seller can juggle the company’s assets and liabilities in ways that reduce the company’s future cash flows without affecting its EBITDA or, in turn, the purchase price. To protect the buyer’s interest in those future cash flows, many M&A transactions include a working-capital hurdle.
Generally, working capital is defined as the operating liquidity available to a company. It’s usually calculated as current assets (excluding cash) less current liabilities (excluding debt), but the specific calculation of working capital for a transaction is defined in the stock-purchase or asset-purchase agreement. Some deals might include cash and/or debt in the working capital or exclude certain current assets and/or liabilities, such as accrued interest expense or income taxes.
A working-capital hurdle is a predetermined working-capital amount that is assumed in the purchase price. For example, a deal might include a purchase price of $55m based on the seller’s delivery of $8m of working capital at closing. The working-capital hurdle could also be set as a range ($7.5m to $8.5m, for example). The purchase price would be adjusted up or down based on the actual working capital at closing.
The adjustment is often made on a dollar-for-dollar basis. In the example above, with a hurdle of $8m, if the seller delivers only $7.5m of working capital, the purchase price would be adjusted to $54.5m. Conversely, if the seller delivers $8.5m, the price would become $55.5m.
The adjustment is not always dollar-for-dollar; it could be derived from a tiered structure. In such a case, if working capital comes in at $7.5m to $8m, the purchase price would drop by a predetermined amount. If the working capital is $7m to $7.49m, the price would be reduced by a larger predetermined amount, and so on.
The need for working-capital hurdles
A working-capital hurdle is intended to ensure that the buyer receives the expected mix of assets and liabilities (that is, the company’s normal working capital needed to run the business) in the transaction. It’s possible to change the mix of current assets and liabilities without affecting income and EBITDA so that a seller could maintain its EBITDA but not deliver the promised mix. As a result, the buyer would end up with less future cash flow than it had bargained for.
Specifically, the seller could manipulate assets and liabilities by doing one or more of the following:
Aggressively collecting accounts receivables.Suppose the company normally collects its accounts receivables in 45 days, but the seller manages to get its customers to pay in 25 days, shortly before closing. If the accounts receivables are usually around $10m, but the seller leaves only $5m in receivables, the buyer will not receive the expected future cash flow from receivables.
Liquidating inventories.The seller could reduce its production and inventories-for-sale. When the buyer then takes over the company, it will have less inventory to sell and will need to incur higher-than-expected costs to rebuild inventory levels.
Slowing payment of accounts payable.Instead of paying its vendors in the typical 30 days, the seller might stretch its payments to 60 days. The buyer then would face higher-than-expected obligations when it takes over.
Working-capital hurdles provide protection and benefits to both parties of a transaction. A working-capital hurdle protects the buyer by reducing the purchase price to the extent the above actions reduce the amount of working capital delivered. At the same time, the seller receives a higher purchase price for delivering working capital above the hurdle. A working-capital hurdle also will help the buyer deal with less egregious issues that can affect a deal’s bottom line. Consider, for example, a target company that does not maintain an accounts-receivable allowance for bad debt. During due diligence, the buyer determines that the company should have reported a $200,000 allowance throughout the year preceding the transaction. If adjustments are made to provide for a $200,000 allowance on 1 January and 31 December, the net income effect will be $0, and EBITDA – and the purchase price – will not change. But the balance sheet overstates the asset balance for accounts receivable by $200,000, thereby overstating working-capital. With a working-capital hurdle that provides for adjustments for such overstatements, the purchase price would drop by $200,000.
Finally, a working-capital hurdle can also pre-empt certain noncash-flow issues. For example, if a seller stretches accounts payable, it could alienate vendors, creating a thorny situation when the buyer takes over. A hurdle increases the likelihood that the buyer will obtain the expected relationships in addition to the expected cash flows.
Calculating the working-capital hurdle
The most common method for calculating a hurdle is based on the average monthly adjusted working capital over a 12-month period. The monthly working capital is determined according to the stock-purchase or asset-purchase agreement. An agreement might, for example, define working capital as: (i) current assets (excluding cash); (ii) less current liabilities (excluding debt); (iii) less items that are excluded by definition in the purchase agreement; or (iv) plus or minus pro forma or due diligence adjustments determined during the financial due diligence analysis (such as the need for a bad-debt allowance).
A 12-month analysis is not appropriate in every situation. If the company is experiencing substantial growth, for example, a 12-month working-capital analysis might not reflect the company’s current working-capital needs.
If revenues grew 75 percent in the second half of the year, it’s likely that the working capital at closing will be higher than a hurdle calculated on a 12-month average, which would drive up the purchase price. In this case, the hurdle might best be calculated on the most recent three or six months.
Seasonality should also be considered. Twelve-month-hurdle calculations generally factor out seasonality, but, depending on whether the purchase is made in or out of season, actual working capital could be much higher or lower. If the deal is made during peak season, working capital is likely to be higher than average, and the buyer would be required to pay more. If the transaction is completed at an off-peak time, working capital will probably be lower than average. With a seasonal business, it might make sense to calculate the hurdle based only on the seasonal or nonseasonal period, depending on when the purchase occurs.
A hurdle that shouldn’t be removed
The working-capital hurdle protects the buyer from changes in the targeted company that won’t show up in EBITDA but could reduce expected future cash flows. Like everything else in an M&A transaction, the hurdle amount is open to negotiation. However, the existence of the hurdle usually should be nonnegotiable.
Adam Haberman is a senior manager and Tom M. Vande Berg is a partner at Crowe Horwath LLP. Mr Haberman can be contacted on +1 (312) 857 7520 or by email: email@example.com. Mr Berg can be contacted on +1 (317) 706 2731 or by email: firstname.lastname@example.org.
© Financier Worldwide
Adam Haberman and Tom M. Vande Berg
Crowe Horwath LLP