Working Capital Adjustments in Commodities M&A Transactions By John Secor and Ajit George Working capital is a well-understood reality to business 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 | COMMODITY 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 inventory 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 businesses given that they hold significant inven- revolving credit 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 debt. 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 accounting terms, working capital is simply defined as the difference between current assets and current liabilities. The concept of a working capital mechanism is that the purchase Balance sheet items typically included are cash, inventory, price determined on the signing date is contingent on receiving an accounts receivable, short-term debt and accounts payable. 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 loans 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 9/30/2015 12/31/2015 9/30/2015 12/31/2015 Selected Balance Sheet Items (millions) (millions) No 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 $80 $100 Short-Term Debt $43 $63 $63 Short-Term Debt $43 $63 Long-Term Debt $5 $5 $5 Accounts Payable $40 $40 Current Liabilities $83 $103 Cash $5 $5 $5 Net Debt $43 $63 $63 Long-Term Debt $5 $5 Equity Value 2 $57 $37 $57 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 corporate finance, 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.