Ask the Expert with Steve Plaskitt: How working capital impacts deal valuations
As every SME company owner knows, managing cash and your working capital is absolutely critical to keeping your business running. “Cash is King” – it was before the Pandemic and it still is afterwards.
But when it comes to deals and valuations of companies, how much cash needs to be kept for working capital? And given the most recent two year period, how you do know what a normal amount is especially when the last two years trading have been anything but normal?
In simple terms, the valuation of a company is the valuation of the business (typically a multiple of its maintainable profits) plus the Excess Cash that it has at the time of the sale less the Debt that it has. Other than an overdraft or invoice finance, most of the Debt in a SME is long term debt and doesn’t move significantly from week to week in the company.
Cash (and so, overdraft) is not like this – it moves daily as receipts come in and payments are made; it will fluctuate with regularity within each month eg when HMRC is paid mid month or when salaries are paid at the end of the month; and it will move cyclically within each year eg due to seasonality of sales.
So when it comes to define Excess Cash in a deal, there is always a debate about what the level of Excess Cash is and how much money is required to manage the working capital of stock, debtors and creditors.
Too often this issue is not dealt with early during a deal process and is not fully addressed in heads of terms. This can lead to substantial changes in the expected value of a deal from the vendor’s perspective, or in extreme cases, of deals collapsing later on when neither the seller nor the buyer can agree on what is the suitable valuation adjustment.
Even for those deals that are well advised and where the issue has been addressed early, and historic monthly balance sheet information shared, often it is difficult for a buyer to accept the definitions as they have not had chance to look into greater detail to assess whether the historic balance sheets show a normal working capital and cash position.
There are a number of ways a buyer would look at this:
- Granular normalised working capital: this is where the typical trading terms for working capital are identified and applied to the stock, debtors and creditors to create an estimate of what would be the normalised working capital position.
- Historic normalised working capital: where the focus is looking back for a period of a year to establish what a normal level of stock, debtors and creditors would be; identifying adjustments and one off occurrences within this period; and using this to make an average target requirement for working capital which can be compared to the working capital levels at completion and allow an adjustment in valuation to take place.
- Forecast cash requirements: looking forward for the next few months to ensure that Excess Cash would mean that a trade buyer does not need to inject additional monies in to the business typically to fund loss making periods or address seasonality in the business.
All these ways have their relative merits and there is no set way to defining excess cash or normalised working capital adjustments – though some serial buyers may have their own preferred ways, as would their corporate finance advisers.
At MHA Tait Walker Corporate Finance, our team is very experienced at deal handling and negotiation and we have invested significantly in our data analytics and due diligence capabilities so we can advise both buyers and sellers from all perspectives.
Agreeing on the final valuation impact towards the end of a deal process becomes part of the final points of negotiation. Often this is when emotions are running higher and it is being negotiated along with many legal matters which will have arisen during the due diligence period.
Even before the valuation adjustments are known, there needs to be a decision about exactly what legal mechanism will be used in the final share purchase agreement. In short, there are two typical methods by which the lawyers can put the wording in the legal agreements:
- Locked Box: where the valuation adjustment is agreed before completion and so gives the vendor certainty at completion and a known valuation adjustment; and
- Completion Accounts: where the finer detail is worked out only after completion when a set of one-off accounts are produced. This allows the final working capital position to be compared to a target and a balancing payment for working capital and excess cash to be made a couple of months after completion of the deal.
Either way has relative merits though it is more common for smaller deal sizes (ie below £5m) to have completion accounts as the selling company may have less reliable financial information and experience large cash swings which would mean that establishing an accurate normalised position of working capital is difficult. Whilst this is more common, it is also a little more expensive as it requires greater scrutiny by all sides during due diligence, but it brings the additional benefit of seeming to be fair to both parties.
Due to the Pandemic, working capital patterns will have changed for many businesses and so negotiating excess cash and normal working capital positions in the final valuation impact is increasingly both an art and a science – the art of negotiation meeting the science of data analysis in due diligence.