Partner, Transaction Services Group
Crowe Horwath LLP
The purchase price in the majority of merger-and-acquisition transactions is calculated using a common formula: Multiply the target company’s earnings before interest, taxes, depreciation and amortization (EBITDA) by an agreed-upon multiple.
However, Tom Vande Berg, a partner with Crowe Horwath LLP’s Transaction Services Group, says a seller can juggle a company’s assets and liabilities before the deal is finalized in ways that reduce its future cash flows without affecting its EBITDA.
“This can lead to the purchase price staying the same, although the company’s future cash flows could be considerably different than what the buyer expected,” he says.
This is where a working capital hurdle can be used to protect the buyer’s interest in future cash flows.
Smart Business spoke with Vande Berg about working capital hurdles and how they can positively affect M&A transactions.
What is a working capital hurdle?
A working capital hurdle is a predetermined amount of working capital built into the purchase price of a business. It can be a specific amount or set as a range, and it can be adjusted up or down based on the actual working capital at closing. Working capital hurdles help protect the buyer from changes in the targeted company that don’t show up in EBITDA but that have the potential to reduce expected future cash flows.
The adjustment typically is dollar for dollar, but it could be derived from a tiered structure in which the purchase price would change by a predetermined amount based on available working capital when the deal closes.
What is the benefit of working capital hurdles?
A working capital hurdle attempts to include in the transaction the normal working capital needed to run the business. Without the protection of a working capital hurdle, the buyer could end up with less future cash flow than bargained for because it is possible for a seller to maintain its EBITDA but not deliver the promised mix of assets and liabilities.
A working capital hurdle also has noncash-flow benefits such as increasing the likelihood the seller will maintain normal course business relationships.
Assuming cash is excluded from the definition of working capital, a seller could manipulate its assets by aggressively collecting accounts receivable. If receivables are reduced ahead of the transaction, the buyer will not receive the expected future cash flow from them.
A seller also could liquidate inventories by reducing production and inventories for sale. When the buyer then takes over the company, it will have less inventory to sell and will need to incur higher-than-expected costs to rebuild inventory levels. Another possible detrimental action by the seller is slowing payments of accounts payable, which will leave the buyer facing higher-than-expected obligations when the company is acquired.
A working capital hurdle can pre-empt certain noncash-flow issues, such as any ill will that might develop among vendors if a seller stretches accounts payable ahead of closing. It can also help a buyer deal with other issues that affect a deal’s bottom line.
For example, consider a target company that does not maintain an accounts receivable allowance for bad debt. Say the buyer finds that the company should have reported an allowance throughout the year preceding the transaction. Adjustments made by the seller to provide for the allowance at the beginning and ending dates of the analysis period will make it look as if there was no net income effect, and both the EBITDA and the purchase price will not change. However, the balance sheet could overstate the asset balance for accounts receivable, which means it has also overstated working capital. Hurdles can include adjustments for such overstatements and would result in a lower purchase price.
Sellers can also benefit from a working capital hurdle, as it can create a higher purchase price for delivering working capital above the hurdle.
How is the amount of a hurdle determined?
Most often, a hurdle is calculated based on the average monthly adjusted working capital over 12 months. The asset or stock purchase agreement might, for example, define working capital as current assets (excluding cash), less current liabilities (excluding debt), less items that are excluded by definition in the purchase agreement plus/minus pro forma or due diligence adjustments determined during the financial due diligence analysis.
However, a 12-month analysis is not always appropriate because, for example, it might not reflect the company’s current working capital needs if it is experiencing substantial growth. If revenue has grown 75 percent in the second half of the year, it is likely that the working capital at closing will be higher than a hurdle calculated on a 12-month average, which would drive up the purchase price. In this case, the hurdle might best be calculated based on the most recent three or six months.
It is also important to note that 12-month hurdle calculations generally factor out seasonality, but working capital levels could swing significantly depending on whether the purchase is made in or out of season. During a peak-season purchase, working capital is likely to be higher than average, leading to a higher purchase price, while the opposite is true for an off-season purchase.
Like most points in an M&A transaction, the hurdle amount is open to negotiation. However, the existence of the hurdle should usually be non-negotiable.
Tom Vande Berg is a partner with Crowe Horwath LLP’s Transaction Services Group. Reach him at (214) 777-5253 or [email protected].
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