UNDERSTANDING WORKING CAPITAL ADJUSTMENTS AT CLOSE: A CEO'S GUIDE
Understanding Working Capital Adjustments at Close: a CEO's Guide
As a CEO planning to sell your private company, one of the most critical aspects to understand is how working capital adjustments will affect your final sale price. These adjustments help ensure that the buyer receives a business with an appropriate level of operational liquidity. Key considerations include the "cash-free, debt-free" (CFDF) structure, as well as adjustments for deferred revenue and past due accounts.
What Are Working Capital Adjustments?
Working capital adjustments are made to align the working capital at closing with a predetermined target amount. This is crucial for ensuring the buyer can operate the business effectively post-acquisition without facing unexpected financial challenges.
Key Components of Working Capital:
- Current Assets: Cash, accounts receivable, inventory, and other short-term assets.
- Current Liabilities: Accounts payable, accrued expenses, and short-term debts.
CFDF Structure
In a CFDF transaction, the sale price is calculated without considering any cash reserves or outstanding debts. This structure simplifies the financial arrangement and provides clarity for both the seller and the buyer.
How It Works:
- Determine the Enterprise Value (EV): The EV reflects the total value of the business, typically based on a multiple of earnings or cash flow.
- Adjust for Cash and Debt: The final purchase price is adjusted by excluding cash on hand and accounting for any debts, providing a clearer picture of the business’s operational value.
Example of a CFDF Calculation:
- Enterprise Value (EV): $6 million
- Cash: $1 million
- Debt: $500,000
Adjusted Purchase Price Calculation:
Adjusted Purchase Price = EV + Cash – Debt =
$6,000,000 + 1,000,000 - 500,000 = $6.500.000
Thus, the seller would receive $6.5 million at closing. Generally, the buyer would require seller to take the excess as dividend and not bump up the closing price.
Conversely if the cash values were reversed the seller would receive $5.5 million at closing. The buyer in this case would apply $500,000 of the EV to the debt.
While the CFDF calculation is straightforward, defining what cash and debt may not. For example, outstanding cheques may be treated as a reduction to cash balances and payment of debt. Or sometimes they may be classified as liabilities at close. Some companies may only do this re-classification at year end.
So, what is the cash balance to be retained by the seller? If the outstanding cheques are not reflected within the cash balances, they are treated as debt-like by the buyer. In others words the seller takes all the cash in the bank but the transaction proceeds may be reduced by the amount of outstanding cheques on the books.
Why does this matter? In general, it is more tax efficient for the seller to receive sale proceeds from a buyer as capital gains than receiving dividends. In most cases capital gains have a lower marginal tax than dividends.
Buyers and sellers need to be in agreement and have clear documentation covering items like this.
Adjustments for Deferred Revenue
Deferred revenue, or unearned revenue, represents funds received for goods or services yet to be delivered. This is a liability on the balance sheet and should be factored into working capital calculations.
Example of Deferred Revenue Adjustment:
- Total Deferred Revenue at Closing: $300,000
- Target Deferred Revenue (based on historical averages): $250,000
Adjustment Needed:
Adjustment=Actual Deferred Revenue−Target Deferred Revenue Adjustment= $300,000 − $250,000 = $50,000
In this case, the EV would need to be reduced by $50,000 adjustment at closing to account for the excess deferred revenue. This example assumes the buyer and seller have negotiated how Deferred Revenue Adjustment is to be treated.
If this adjustment is not addressed during negotiations and Generally Accepted Accounting Principles (GAAP) were applied at closing, all deferred revenue at the time of closing would be treated as debt. Applying this situation to the above example, the seller would see the EV reduced by $300,000.
Addressing Past Due Accounts
Past due accounts receivable represent money owed to the company that is overdue. These accounts can impact working capital and should be assessed carefully.
Example of Past Due Accounts Adjustment:
- Total Past Due Accounts at Closing: $100,000
- Acceptable Past Due Level (based on historical collection rates): $60,000
Adjustment Needed:
Adjustment = Total Past Due − Acceptable Level Adjustment =
$100,000 − $60,000 = $40,000
The EV would be reduced by $40,000 to reflect the risk associated with these overdue accounts.
This example again assumes the buyer and seller have negotiated and reached agreement regarding how past due accounts will be treated. If not addressed, sellers will want to deduct all past due accounts from the company’s working capital.
Best Practices for Managing Adjustments
- Establish Clear Targets: Set clear working capital targets before negotiations, considering historical performance, seasonality, and other operational factors.
- Documentation is Key: Maintain detailed records of all financial metrics related to working capital, including historical data on deferred revenue and accounts receivable collections.
- Define the Process: Clearly outline how working capital and adjustments will be calculated in the purchase agreement, including definitions for deferred revenue and what constitutes past due accounts.
- Prepare for Disputes: Establish a process for resolving disputes over working capital adjustments, such as involving an independent third-party expert for arbitration.
Conclusion
Understanding working capital adjustments—especially in a CFDF context—is vital for private company CEOs as they navigate the sale process. By setting clear targets, documenting financials accurately, and being prepared for negotiations, you can safeguard the value of your business and facilitate a smooth transition to new ownership. With thorough preparation and expert guidance, you can turn a potentially complex process into a successful exit strategy.
The Shaughnessy Group We are advisors in finding, growing, buying and selling your business.