The process of acquiring a company is a lengthy undertaking which, when completed smoothly, does not significantly impact its normal operations. As many deals are done on a cash-free, debt-free basis, the post-closing balance sheet should reflect the true nature of the working capital of the company which differs from the traditional accounting-centric definition. Therefore, understanding a target company’s working capital cycle is a critical component in helping your client to negotiate a fair transaction and to ensure the smooth transition of control.
The type of deal described above typically begins with a letter of intent that has language in it relating to the seller leaving an appropriate amount of working capital in the business to ensure it continues to operate without interruption. As the deal nears completion, setting an accurate working capital target and definition for the purchase agreement is crucial so that undefined liabilities do not become the responsibility of the purchaser.
As such, deal-related working capital can consist of some or all of the following balances:
Determining which of the above components exist can be achieved through careful due diligence. Common steps in doing so consist of:
A well-understood and defined working capital target should ultimately leave both the purchaser and vendor on equal footing. The difference between the target working capital and the post-closing working capital (a period defined in the purchase agreement to allow for the books to be cleaned up post-acquisition) ultimately results in a downward or upward adjustment to the purchase price where both sides should feel comfortable about the deal you helped advise them on.