Why working out working capital is so important for M&A

ONE of the real sticking points that crops up in mergers and acquisitions (M&A) continually is the allocation of ‘working capital’.

That has been the experience of Pitcher Partners Brisbane, which has seen the issue emerge in both large and small acquisitions. 

“Whilst ‘working capital’ is generally comprised of monetary items that will crystallise short term into cash inflows/outflows, it is fair to say one man’s definition or interpretation, is generally not that of another,” Pitcher Partners Transaction Services partner Warwick Face said.

He said the key to a successful completion of an M&A deal was to have working capital’s components properly defined, as even textbook definitions of it varied. He said the accounting basis and policies for working capital needed to be defined, such as using the International Financial Reporting Standards (IFRS).

“Utilise experienced lawyers, and ideally have these terms agreed upfront,” Mr Face said. “Ensure you involve an experienced M&A accountant alongside your lawyer.”

In the experience of Pitcher Partners, Mr Face said, when negotiating the enterprise value (EV) at which to acquire or divest a business, in the most simple terms this reflected fixed assets, such as plant and equipment; intangible assets such as brands, and intellectual property; operating assets or ‘normal working capital’ such as debtors, stock and creditors; and a residual amount of business goodwill.

“Businesses need cash to function, they must be able to fund receivables, carry inventory, and pay suppliers and wages,” Mr Face said. “Acquirers will generally value a business on the assumption it contains a ‘normal level’ of working capital.

“Each business and industry sector have different dynamics, and it is not uncommon for ‘interesting arguments’ to enter negotiations particularly in businesses which collect money in advance, for example subscription software, or project and construction businesses.”

Mr Face said it was important for purchasers to understand a target’s working capital.

This included an understanding of what were the industry norms, including seasonal and historical levels of working capital.

ACCOUNTING FOR CAPITAL CHANGES

In the real world, an adjustment of the transaction price for any M&A completion usually takes into account natural fluctuations in working capital.

“Assuming agreement on ‘normal working capital’, the business reality of collections and payments, means that the components at the date of the original offer may vary materially versus those at transaction completion,” Mr Face said.

“A working capital completion mechanism is generally inserted into a sale/purchase agreement (SPA) whereby the agreed EV is adjusted to account for such shifts,” he said.

“These mechanisms are also a source of robust debate, and often despite supposed agreed/understood terms, are also a key area of post completion dispute.”

Mr Face said that was why Pitcher Partners always recommended businesses engage experienced lawyers and an M&A accountant to help these sometimes complex transactions to run smoothly.

Pitcher Partners is an Industry Expert member of Queensland Leaders, the organisation helping to develop and mentor the next generation of leading Queensland companies.

www.pitcher.com.au

 

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