CPAs & ADVISORS WORKING CAPITAL AND AVOIDING PURCHASE PRICE DISPUTES Matt Klauser, CPA, CM&AA
AGENDA What is a working capital target and post-closing adjustment? What types of pro forma adjustments may be included? What methodologies can be utilized to calculate a working capital target in an acquisition? What are examples of common items that can lead to post-closing disputes? How do generally accepted accounting principles (GAAP) differ from past practices in terms of influencing the working capital target and adjustment? What are common questions received from Sellers? Questions from the audience (including questions submitted in advance) 2
ARE YOU READY FOR TONIGHT? 3
WHAT IS A WORKING CAPITAL TARGET? Working capital is required to operate the business Sellers are frequently valued on a cash-free, debt-free basis Would your company exist if it did not extend credit to customers or purchase/manufacture inventory in advance of the eventual sale? Buyers don t want to have to utilize a line of credit to fund the short-term working capital needs of the company post-closing As a result, Buyers require Sellers to deliver a normal level of working capital at closing to fund operations post-closing this is known as the working capital target (or peg) The working capital target is negotiable, similar to the preliminary valuation Consider including an example calculation in the purchase agreement specifying exactly which accounts will be included in working capital 4
WHAT IS A POST-CLOSING ADJUSTMENT? At closing, actual working capital is measured and compared to the target If actual working capital is greater than the target, purchase price is increased, and vice versa (usually two-step process) Typical process for calculating actual working capital is as follows: A few days before closing, Seller provides estimate of working capital and the purchase price at closing includes an adjustment equal to the difference between the estimate and the target Within a specified time period post-closing, Buyer prepares actual working capital and delivers to Seller Seller has specified time period to review Buyer s calculation If agreement cannot be reached, disputed amounts are presented to independent third-party for resolution Eventually, purchase price is adjusted for the difference between actual working capital and the estimate 5
EXAMPLES OF PRO FORMA ADJUSTMENTS Remove assets and liabilities excluded from the transaction Cash, debt, related party, income taxes GAAP adjustments Reserves and accruals more on this later Interim vs. year-end accounting Consistency of adjustments made only at each quarter-end or year-end Changes in the business Customer payment terms Inventory purchasing patterns Adjustments to EBITDA Add back excess compensation costs, exposures related to reserves, etc. One-time/non-recurring accruals 6
TARGET WORKING CAPITAL METHODOLOGIES How was the valuation determined? Simple historical average (commonly last 12 months but could be longer or shorter) Working capital as of a recent date Ratio of working capital to EBITDA (or sales) multiplied by the EBITDA (or sales) used in the valuation Expected working capital at closing Projected working capital at a future date Almost anything you can imagine 7
ITEMS THAT LEAD TO POST-CLOSING DISPUTES Overcommitting before completing working capital diligence Not completing working capital diligence early in the exclusivity period Using vague or misleading wording in the definitive agreement and assuming we will handle it post-closing Using the working capital adjustment in an effort to close a gap related to the preliminary valuation Not understanding the significance of the working capital adjustment Trying to go it alone and not utilizing individuals experienced in the subject matter Lack of clarification regarding GAAP vs. past practices 8
GAAP VS. PAST PRACTICES Will working capital be computed in accordance with GAAP, or consistent with the company s past practices? Beware of the dreaded comma! If you use the dreaded comma, which one prevails? Buyers may lean towards GAAP (to align with cash flow expectations) while Sellers may lean towards past practices (for consistency) 9
WHY ARE THESE ITEMS IMPORTANT Do you want to flip a coin to avoid going to arbitration? 10
ADVANCE QUESTIONS FROM THE AUDIENCE Treatment of deferred revenue Often given a haircut when allocating purchase price is that considered when calculating the working capital target? Methodology in a professional services organization such as a consulting firm No inventory and employee time is billed against jobs 11
COMMON QUESTIONS FROM SELLERS Should I be able to keep the accounts receivable and inventory at closing since I paid for it? If Buyer is going to acquire my accounts receivable and inventory, should they have to pay me for it? Why would I agree to a working capital target that is significantly different from expected working capital at closing? Should seasonality influence the working capital target? Why do I have to include a working capital target? What happens if my company has negative working capital? What is a collar? What is a one-way adjustment? How do you handle accounting estimates in closing working capital where GAAP may accept multiple answers? 12
THANK YOU FOR MORE INFORMATION // For a complete list of our offices and subsidiaries, visit bkd.com or contact: Matt Klauser, CPA, CM&AA // Senior Managing Consultant mklauser@bkd.com // 816.701.0288