Tuesday, October 18, 2005

Working Capital

Brad Feld is running a very informative series on Letters of Intent; the latest post covers price and structure. Brad's comments on working capital shouldn't be taken lightly just because in his example they only account for $1 million in a $150 million deal - working capital is an area where it's very easy for the parties to talk past each other and end up with a very ugly dispute during negotiation of the definitives or even post-closing. It's also an area where you'll want to make sure your accounting professionals are at your side as you draft the LOI and the working capital provisions in the agreement.

While not a major issue in early stage companies, receivables can be a big point of contention in mature company deals, as they can represent several percentage points on the value of a deal. For example, a company selling for $100 million could easily have $4 million in receivables. Absent an explicit discussion of working capital (and many deals get to the point of drafting definitives without ever going through an LOI), the buyer may well assume that the $4 million receivable is an asset included in the purchase price, while the seller assumes it is on top of the purchase price as a working capital adjustment. This is not a negotiation you want to be having after you've already agreed on price.

As the buyer you might even consider detailing in the LOI the treatment of aged receiveables in the working capital adjustment. While you may pay full value for current receivables, you'll probably pay next to nothing (or nothing) for receiveables more than 90-120 days old, and a sliding scale in between. This will be a negotiation of its own, as it directly impacts purchase price. A lot will depend on where you are in diligence, whether the business is similar to your core business, and what your own internal rules are on creating reserves for receivables.

1 comment:

Parkite said...

What about inventory? How do you get comfortable wrt to the quality of inventory included in a deal? Does someone, on behalf of the buyer, go out and do a physical prior to close? Depending on the company, inventory may or may not be material.

On the liability side, how do you know payables haven't been understated (omitted; held) to increase working capital? I guess you could hire an acct firm to conduct an audit. Subsequent to the valuation date you probably have to look at cash flows to determine if anything was purposely omitted.