Steve Plaskitt, head of corporate finance at MHA Tait Walker, gives his take on the impact of working capital on transaction valuations, especially since the start of the pandemic.
As any small business owner knows, managing your cash flow and working capital is absolutely essential to the smooth running of your business. “Cash is King” – that was before the pandemic and still is after.
But when it comes to business transactions and valuations, how much cash needs to be kept for working capital. And given the most recent two-year period, how do you know what a normal amount is, especially when the last two years of trading have been anything but normal?
Simply put, a business valuation is the valuation of the business (usually a multiple of its maintainable earnings) plus the excess cash it has at the time of sale minus the debt it has. Other than an overdraft or invoice financing, most of an SME’s debt is long-term debt and does not move significantly from week to week in the business.
Cash (and therefore overdraft) isn’t like that – it moves daily as receipts arrive and payments are made; it will fluctuate regularly during each month, for example when HMRC is paid in the middle of the month or when salaries are paid at the end of the month; and it will change cyclically over the course of each year, for example due to sales seasonality.
So when it comes to defining Excess Cash in a transaction, there is always a debate about the level of Excess Cash and how much money is needed to manage the working capital of stocks, accounts receivable. and creditors.
Too often this issue is not addressed at the start of a transaction process and is not fully addressed in terms. This can lead to substantial changes in the expected value of a transaction from the seller’s point of view, or in extreme cases, transactions that later collapse when neither the seller nor the buyer can agree on the deal. ‘appropriate valuation adjustment.
Even for transactions that are well advised and where the issue was dealt with early, and historical monthly balance sheet information shared, it is often difficult for a buyer to agree to the definitions because they have not had the opportunity to review in more detail to assess whether historical balance sheets show normal working capital and cash flow.
There are several ways for a buyer to view this:
- Granular Normalized Working Capital: This is where typical business terms for working capital are identified and applied to inventory, accounts receivable, and creditors to create an estimate of what the normalized working capital position would be.
- Historical Normalized Working Capital: when the focus is on a one-year period to establish what would be a normal level of inventory, accounts receivable and creditors; identify adjustments and one-off events during this period; and using this to establish an average target working capital requirement that can be compared to the levels of working capital at completion and allow for adjustment of the assessment.
- Forecast cash flow needs: look to the next few months to ensure that excess cash means that a commercial buyer does not need to inject additional funds into the business, typically to finance periods of losses or to cope to the seasonality of the business.
All of these ways have their relative merits, and there is no set way to define excess cash or normalized working capital adjustments – although some serial buyers may have their own preferred methods, as their own would. business finance advisers.
At MHA Tait Walker Corporate Finance, our team is very experienced in managing and negotiating transactions and we have invested heavily in our data analysis and due diligence capabilities so that we can advise buyers and sellers from all points of view. of view.
Agreeing on the final impact of the evaluation towards the end of a transaction process is one of the final points of negotiation. This is often when the emotions heat up and this is being negotiated along with many of the legal issues that will have arisen during the due diligence period.
Even before valuation adjustments are known, a decision must be made on the exact legal mechanism that will be used in the final share purchase agreement. In short, there are two typical methods by which lawyers can put wording in legal agreements:
- Locked box: when the valuation adjustment is agreed upon prior to completion and thus gives the seller certainty of completion and a known valuation adjustment; and
- Completion Accounts: where the finer details are worked out only after completion when a set of one-off accounts is produced. This compares the final working capital position to a target and a balancing payment for working capital and excess cash to be made a few months after the deal is closed.
Either way has relative merits, although it is more common for small transactions (i.e. capital is difficult. Although this is more common, it also costs a bit more because it requires a more careful consideration of all parties during due diligence, but it has the added benefit of seeming fair to both parties.
Due to the pandemic, working capital models will have changed for many companies and therefore trading excess cash and normal working capital positions in the final impact of the assessment is increasingly to both an art and a science – the art of trading meets the science of data analysis in a timely manner. diligence.