Working Capital in a Business & Asset Sale - Don't Get Tripped Up

There's no shortage of information relating to how working capital is treated in M&A transactions - and for good reason. It's a complex and critical aspect that must be considered in every M&A transaction. However, most of the published information focuses on share sales, leaving a gap when it comes to understanding working capital in the context of a business & asset sale (hereafter called an Asset Sale).

Let's break it down to ensure you are prepared for your next Asset Sale transaction.

WHAT IS WORKING CAPITAL?

Working Capital in the context of an M&A transaction refers to the funds invested in a business to allow it to operate on a day-to-day basis. It is typically calculated by taking Working Capital assets, which are effectively the current assets of a business aside from cash & cash equivalents, less Working Capital liabilities, which are effectively the current liabilities of a business less any financial debt which is categorised as current.

Working Capital, also referred to as Net Working Capital, may be positive or negative depending on the nature of the business e.g. SaaS and other services business that collect payment in advance of providing services often operate with negative Working Capital.

HOW IS WORKING CAPITAL TREATED IN A SHARE SALE?

In a Share Sale, the Buyer is acquiring all assets and liabilities of the Target, part of which is the Working Capital.

The Buyer is interested in making sure the Target is holding a normal amount of working capital when it acquires the Target, so that the Buyer can operate the business without providing further funding for working capital post-acquisition. To achieve this, the Buyer usually makes its offer subject to a normal amount of Working Capital being held at completion, and a Target Working Capital which represents what is considered 'normal' is negotiated with the Seller following due diligence.

An adjustment to the purchase price is made post-completion if more or less than the Target Working Capital is left by the Seller at completion.

IS WORKING CAPITAL TREATED IN THE SAME WAY IN AN ASSET SALE?

Now in an Asset Sale scenario, while the Buyer typically purchases Inventory, the Buyer usually doesn't purchase any other Working Capital of the Target, as debtors and creditors typically remain with the Seller. The Seller collects the debtors and settles the creditors outside of the sale transaction.

This means that in an Asset Sale, aside from Inventory, any other Working Capital needs of the Target business will need to be funded by the Buyer in addition to the purchase price.

It also means that any reference to a normal amount of Working Capital in a term sheet / non-binding offer / letter of intent for an Asset sale won’t hold any relevance, except with respect to Inventory. If Inventory is being acquired, the Buyer would typically make its offer subject to a normal amount of Inventory being held at completion, and in the long-form binding sale documents, there will usually be provisions around how the value of Inventory at completion is calculated (addressing age of the Inventory, obsolescence, stock take procedure etc.).

This leads us to the key take-outs for an Asset Sale:

1. From the perspective of a Buyer:

   • Any Working Capital needs of the Target should be considered when formulating an offer for the business, with the calculated purchase price lowered to the extent of the positive Working Capital that the Buyer will need to fund.

   • The difficulty in this regard is that the Buyer often has limited financial information at the offer formulation stage, so properly assessing the Working Capital of the Target might be difficult.

   • If the Buyer already operates in the industry of the Target however, they should have a good feel for industry norms around Working Capital.

     
     

2. From the perspective of a Seller:

   • The Seller needs to be mindful that the Buyer may want to lower its purchase price to the extent of any positive Working Capital the Buyer will need to fund.

   • The key for the Seller is to ensure it doesn’t short-change itself by accepting an offer which nets the Seller a lower result overall after the collection of its debtors and payment of its creditors.

TAKE ADVICE

Don’t guess when it comes to buying or selling a business. Ensure you obtain appropriate advice from an experienced Corporate Advisor so that key aspects of the transaction, like treatment of Working Capital, are appropriately addressed prior to negotiating a term sheet.

Contact Zealth Advisory for any M&A needs. We are mid-market specialists and work with buyers and sellers on transactions ranging from $1m to $100m.