The Importance of Setting Net Working Capital Pegs and/or Floors

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Who Owns the A/R, A/P and Inventory When Selling or Buying a Business?

While all transactions are as unique as the parties involved, in most business sale transactions the seller keeps the cash (unless it is a financial services company where cash IS inventory) - but what about A/R, A/P and Inventory? In order to maximize the value of the enterprise, the seller needs to hand over a working business and that means enough working capital - AKA ‘fuel in the tank’ to keep the business running. A good analogy is buying a car - you certainly wouldn’t buy a car and need to put in gasoline and oil (or charge the battery of an EV) before you could drive it off the lot - and the same thing holds true when selling your business. Buyers anticipate buying the business along with a normal level of working capital (A/R, A/P and inventory) to keep the business running after the sale closes.

What is typical in most transactions is to determine what the normal level of working capital should be, based on the history provided by the seller. When the deal is at that early stage where you are about to select a single buyer to move forward with into due diligence, part of their letter of intent (LOI) will typically set a net working capital peg - the level of A/R, A/P and inventory they believe is normal for your business. The idea of a peg is to remove all doubt about what is expected at closing and puts the Net Working Capital Adjustment to work. In some cases as the transaction moves forward during due diligence, additional factors are uncovered which result in a change in Net Working Capital - while this is an adjustment in the peg, it is not considered a Net Working Capital Adjustment which is reserved for adjustments made at closing to reflect the difference between the peg and actual Net Working Capital.

Net Working Capital Adjustment

For example, let’s say the seller and buyer agree that a normal level of A/R is $2m and the normal level of A/P is $300k while the company needs 3 months of inventory including finished goods and work in process valued at $3.4M so our net working capital (A/R + Inventory - A/P) is $5.1m. The net working capital peg would be set at $5.1M in this example and if at close the value of net working capital is $6m resulting in a net working capital adjustment in favor of the buyer. Put another way, the buyer will pay the seller an additional $900k at closing to adjust the net working capital to ‘normal’ levels agreed upon in the LOI. Conversely, if the value of net working capital at close is below the peg, the seller will pay the buyer the difference.

Sometimes the seller’s accounting can cloud the picture, let’s say for example the seller maintains inventory on a non-GAAP (Generally Accepted Accounting Principles) basis. As a result neither the buyer or seller are able to establish a normal level for inventory. A common solution to this problem is to set a floor for inventory and there is no allowance for excess inventory because neither party can determine what is the right level of inventory so they agree on an arbitrary number like the average inventory value for the last 12 months. In this case, there are payments by the seller to the buyer if the inventory falls below the floor but not payments by the buyer if inventory at closing is greater than the floor.

Why a buyer wants to include A/R in the sale

Purchasing the accounts receivable offers the buyer the advantages of having control over the collection of the receivables and continued cash flow from the business, thereby removing the need to acquire additional working capital. Equally important, the buyer immediately begins dealing directly with the most important element of the business – its customers.

The sale of the accounts receivable also offers the seller a clean break from the business and the ability to cash out. This approach leaves no open-ended accounting issues after closing. The seller needs to provide solid evidence of the collectability of the A/R including A/R aging reports since any receivable over 90 days is less likely to be collected and the buyer will want a discount off the face value of A/R more than 90 days old.

Why a buyer wants A/P included in the sale

It may seem counterintuitive that a buyer would want to take on responsibility for debts (A/P) from the seller. However, by assuming responsibility for the payables, the buyer immediately begins forming their own relationship with another key element of the company — the suppliers, vendors, and other service providers. It puts the new owner in control of dealing with these important contacts instead of the former owner.

The purchase price paid to the owner is reduced by the amount of accounts payable that is being assumed by the buyer (remember net working capital = A/R + Inventory - A/P). Then the buyer, as the new owner, pays the invoices as they become due. An accounts payable report and an A/P aging report are critical tools in helping buyer and seller determine the reduction in price paid at closing by the buyer for assuming the responsibility of paying the outstanding invoices.

Successful Working Capital Adjustments

In order to have a smooth, timely, and agreeable working capital adjustment, the purchaser and seller should come to some basic understandings and agreements in the early phases of a transaction process. This includes an understanding of the definition for any accounting terms used in the working capital equation (and what assets and liabilities may be excluded) along with a reference balance sheet.

Additionally, the purchaser and seller should make some decisions about:

– What accounting standard will be applied? Will GAAP or previous financial reporting standards be followed?

– Will the statements be audited or reviewed by a CPA firm?

– In the event of a dispute, will you work with an expert or an arbitrator?

The definitions, computation, and dispute methodology related to the working capital adjustment are equally important to the business seller and buyer. So communicating about this important deal term early in the acquisition process is always a good practice.