Working Adjustments in M&A Transactions By John Secor and Ajit George

Working capital is a well-understood reality to owners – it is the funds required to manage a company’s day-to-day operations. It reflects the balance of collections from customer payments and the disbursements made to suppliers. However, the calculation and treatment of working capital is often complex and heavily negotiated in a sale transaction. Buyers want to ensure the acquired business is able to continue meeting short-term operating requirements post-closing, as they would need to pro- vide additional capital if a seller failed to do so. Sellers, on the other hand, want to be adequately compensated for business that they have already performed and are cau- tious about handing over more working capital than necessary at closing.

18 Brown Brothers Harriman | MARKETS UPDATE Acquisition agreements typically include working capital adjust- As noted, the adjustment mechanism is particularly important ments in order to protect against potential adverse shifts in for commodities firms because their balance sheets are primar- value and ensure the new business has the appropriate level of ily composed of that is exposed to commodity price working capital. These adjustments are particularly relevant for volatility, and these fluctuations are often funded with short-term commodities given that they hold significant inven- revolving facilities. The working capital levels at any point tory that is subject to price volatility and largely financed by in time may reflect transient variations due to changes in com- short-term secured . A well-constructed working capital modity prices, volumes, seasonality (for example, crop seasons adjustment mechanism negotiated early in the process will pro- in the case of agricultural and weather in the case of energy) or tect both buyer and seller, prevent last-minute surprises and even purchase and delivery contracts (that is, holding product on provide a greater level of certainty that the transaction will close. behalf of clients). If not properly structured and negotiated, the mechanism can be an unforeseen way for a commodity business Defining Working Capital to lose significant value in a sale transaction. In terms, working capital is simply defined as the difference between current and current liabilities. The concept of a working capital mechanism is that the purchase items typically included are , inventory, price determined on the signing date is contingent on receiving an , short-term debt and . agreed target level of working capital at closing. The target level These components represent items critical to a company’s is often established based on a historical average. If the value of daily operations and revenue generation. Because most the business is based on the last 12 months’ EBITDA, the aver- transactions are completed on a “cash-free, debt-free” basis age working capital over the same period is likely a good starting assuming a normal level of working capital, cash and short- point for determining the target. The simplest method of adjust- term debt are excluded from working capital. Other items ment is a dollar-for-dollar adjustment. If a seller delivers a level of normally excluded may include to officers, intercom- working capital greater than the target amount at closing, it will pany accounts and shareholder receivables – reflecting items receive a dollar-for-dollar increase in purchase price. Conversely, if which are not part of the liquid assets and liabilities necessary to operate the business. While the working capital calcula- tion appears straightforward, the traditional definition is often modified to account for specific characteristics of a business. In a transaction, it is critical that the buyer and seller reach an [T]he adjustment mechanism agreement on the specific current assets and liabilities to be included in the definition of working capital. The accounting is particularly important for principles used to define working capital should also be con- commodities firms because sistent with past accounting practices and industry norms. their balance sheets are primarily Constructing a Working Capital Adjustment Mechanism One complicated and unavoidable issue in a transaction is that the composed of inventory that is purchase price of a business is determined on the signing date, whereas the company continues to operate until being transferred exposed to commodity price to the new owner on the closing date. The period between sign- volatility, and these fluctuations ing and closing typically ranges from a few weeks to a couple of months, during which time the business’s working capital balance are often funded with short-term will inevitably change. Accordingly, best practice is to construct a mechanism to adjust the purchase price for changes in working revolving credit facilities.” capital between signing and closing.

Issue 1 2016 19 a seller delivers less working capital than the target, the difference prices, which the firm funded via its short-term credit facility. All will be deducted from the purchase price. An effective working else being equal, the impact to the balance sheet was a $20 million capital adjustment mechanism will help to eliminate the impact increase in inventory and a corresponding $20 million increase in of seasonality, shifts in customer demand, changes in payment the credit facility, both of which are illustrated in the nearby table. terms, the addition of new product lines and geographic expan- sion – to name a few – between the signing and closing dates. If the purchase agreement did not include a working capital adjustment, then the burden of the weather event would have ABC Orange Juice Company fallen on the seller. In this case, the buyer would have paid the To put this into perspective, let’s look at the following example same price of $100 million, and the seller would have delivered – depicted in the nearby table – where the owner of an orange a higher level of inventory than anticipated; however, the seller juice company agreed to sell his business for $100 million and would also have been liable for the increased debt incurred, signed a purchase agreement with the buyer on September 30, depending on how working capital is incurred, and thus receive 2015. Both parties agreed that the working capital target should only $37 million of equity value instead of $57 million. It is worth be the $35 million of working capital on the balance sheet as of mentioning that the reverse situation could have occurred. If the September 30, 2015. The buyer was given 90 days exclusivity to price of oranges had plunged, inventory could have decreased, complete due diligence and close the transaction. short-term debt would have declined in tandem, and the seller would have been better off. Between signing and closing, the owner continued to operate the business in the normal course. However, in October, unseason- To avoid this scenario, the buyer and seller incorporated a work- ably cold temperatures damaged orange crops, and orange prices ing capital adjustment clause in the purchase agreement such skyrocketed. To fulfill its floating price order book, the company that there was a target amount of working capital to be deliv- was forced to purchase its share of the crop at substantially higher ered to the buyer on the closing date – in this case, $35 million.

Signing Closing Signing Closing 0201 121201 0201 121201 Selected Balance Sheet Items millions (millions) o Adjustment With Adjustment Cash $5 $5 Purchase Price $100 $100 $100 Inventory $25 $45 Working Capital Adjustment - - 20 Accounts Receivable $50 $50 Purchase Price 100 100 120 Current Assets 0 100 Short-Term Debt $43 $63 $63 Short-Term Debt $43 $63 Long-Term Debt $5 $5 $5 Accounts Payable $40 $40 Current Liailities 10 Cash $5 $5 $5 et Det 6 6 Long-Term Debt $5 $5 Euity alue Working Capital Adjustment millions Working Capital Target at Signing1 $35 Working Capital at Closing $55 Working Capital Increase 20

For illustrative purposes only. 1 Negotiated Target = (Current Assets - Cash) - (Current Liabilities - Short-Term Debt) on Balance Sheet at Signing 2 Equity Value = Purchase Price - Net Debt

20 Brown Brothers Harriman | COMMODITY MARKETS UPDATE Any increase or decrease in working capital would be reim- Conclusion bursed on a dollar-for-dollar basis. While the transaction was Fluctuations in working capital are natural for most businesses, still completed on a cash-free, debt-free basis, the initial offer but the impact is exacerbated for commodity-based businesses price was then adjusted on the closing date, and the seller was where inventory represents a large portion of the balance sheet, able to offset the $20 million of higher debt incurred with the has the potential for large swings given price fluctuations for incremental $20 million received through the working capital the underlying commodity and tends to be financed with short- adjustment. The seller received the equity value expected; the term secured debt. Working capital adjustment mechanisms are buyer received the target working capital expected as well as often a complex point of negotiation for both buyers and sellers incremental working capital that was convertible to the equiv- in the context of acquisition agreements, in part because they alent incremental amount of cash that was paid. Both parties lie at the intersection of , accounting and law. were satisfied with this outcome, as the economics of the deal However, a well-advised buyer or seller should be able to con- at signing were maintained. struct the adjustment mechanism that facilitates the transaction and protects both sides from potential value shifts as a result of Determining the Working Capital Target changes in working capital. Addressing working capital early on What, then, is an appropriate working capital target in a in negotiations and closely coordinating among the accountants, sale transaction? Theoretically, it is the normalized level of attorneys, internal finance staff and the deal team will prevent a working capital that enables the buyer to generate the cash working capital dispute from derailing the transaction. flow that is being purchased. In practice, there are various factors that may add complexity to determining this target. For instance, rapidly growing companies often need higher The Corporate Advisory Group (CAG) is dedicated to build- levels of working capital to fund inventory growth. Seasonal ing and expanding relationships with clients and prospects of businesses see fluctuations in inventory and receivables at Brown Brothers Harriman (BBH) Private Banking through an different times in the year. objective long-term corporate finance dialogue. CAG operates outside of the traditional transaction-focused, success fee- The essence here is that there is no straightforward answer – based banking model. As a result, CAG is able to sellers often focus on the headline , but setting approach clients’ unique needs without bias for any particu- the working capital target is a fundamental part of the transaction lar outcome and provide advice to best help clients achieve negotiations and must be mutually agreed upon by both parties. their business and personal goals and objectives. For more information on CAG, please contact your BBH relationship The best way to get comfortable with potential variations is to manager or Charles Shufeldt, Head of Corporate Advisory, at perform an in-depth analysis of historical working capital as part [email protected]. of the negotiation of a letter of intent.1 Sellers should define working capital clearly and develop a strong rationale for the inclusion of any atypical balance sheet accounts that should be included. Working with advisors who are familiar with the indus- try norms as well as precedent transactions can provide a good reference point for the negotiations and ensure that there are no surprises at the closing.

1 Letter of intent: an initial written document that sets out the key terms of a proposed transaction, such as the price and structure.

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PB-03198-2019-11-27 Exp 11/30/2021