Setting the appropriate working capital target is a significant part of any deal, and it's one that is often overlooked until the later stages. Oftentimes, it’s because the seller just doesn't understand the implications until there is a working capital adjustment component of the deal and they see an actual dollar amount.
“That may result in them having to pay back a six-figure dollar amount as part of closing the deal,” says Tony Montanaro, partner in the forensic, litigation & valuation department at Louis Plung & Company. “Setting the target working capital too high, something like that could be good for a buyer because at that point there's excess assets on their books and that could result in value for the buyer.”
If working capital is too low, that could result in the buyer having to make additional investments into the business or borrow more debt.
Montanaro has seen how working capital can bring a deal to a standstill. And there’s no perfect formula for finding that sweet spot.
“This is one of the many aspects of buying and selling a business that involves significant amounts of negotiations,” he says.
To avoid any pitfalls, Montanaro says it’s vital to hire advisers.
“Hire an expert,” he says. “Get a sell-side quality of earning done. Talk to advisers; talk to your attorneys. They will have the necessary experience to lead you to where you need to be.”
And don’t wait too long to begin the process of selling a company.
“This is not something you can change after you get a letter of intent,” Montanaro says. “If you want to make adjustments to your working capital, you want to be doing that six months to a year before you’re looking at any type of transaction.”
There are ways to determine if a company is working with a normalized level of working capital — for example, analyzing other companies in the same industry.
“We’ll go through and look at any industry data that’s available and analyze their ratios to see if the target company is operating at a similar level,” he says.
Working capital can also play a significant role in deal financing, especially when it comes to asset-based lending.
“Typical asset-based lending — some aspect of that — is going to involve working capital,” Montanaro says. “So, when we have significant downward adjustments to working capital particularly close to the closing of the transaction, that could result in a reduction in the amount of the buyer's borrowing base, which in some extreme circumstances could result in them not being able to close deal, or requiring them to make additional Investments post-closing to make up that gap. But either way, it's going to have an impact on them.”
Montanaro spoke on the Smart Business Dealmakers Podcast about the intricacies of working capital in an M&A deal.