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:
- Accounts receivable, net of allowances for doubtful accounts
- Inventory
- Prepaids
- Non-income taxes receivable
- Accounts payable and accrued liabilities
- Other accruals (i.e., payroll, vacations, etc.)
- Non-income tax payable
- Deferred revenue (if not included in indebtedness within the purchase agreement)
Determining which of the above components exist can be achieved through careful due diligence. Common steps in doing so consist of:
- Understanding the target company and whether its working capital is cyclical as well as speaking with management
- Understanding the accounting policies in place and ensuring that proper accrual accounting is followed. This is especially important for interim periods if the target company does not perform regular bookkeeping
- Analyzing the quality of accounts receivable, the salability of inventory, and the relevance of prepaids to ensure good assets are left on the balance sheet
- Observing correct cut-off and accrual procedures at period ends so that unrecorded liabilities don’t creep up post-closing
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.
Written by Greg Shagalovich CPA, CA Senior Manager, Transaction Advisory from Segal GCSE. This document was written for our quarterly bulletin, Canadian Overview, published by Canadian member-firms of Moore North America.