How is the working capital anchor of an acquisition calculated?
At the closing of an acquisition, the investment banker representing the seller calculates the working capital “peg” (WCP), a figure resulting from current assets minus current liabilities, with some exclusions. (A good investment banker continuously models the WCP for the seller long before closing, but the WCP peg is set at the closing of the acquisition, using the very latest balance sheet numbers.)
Assuming the business is being sold on a cashless/debt free basis, let’s examine how the working capital anchor is determined, as there are idiosyncratic exclusions and inclusions when using the very common transaction format without cash/debt free. . On the current asset side of the ledger, the working capital anchor will exclude “cash and cash equivalents,” which all go to the seller. Current assets include inventory, accounts receivable and most prepayments. For current liabilities, the WCP will include accounts payable and most accrued liabilities. By subtracting these current liabilities from the current assets, you determine the WCP. In almost all transactions, there is also a 90-day post-closing “adjustment” adjustment. Note that the inventory value is on the asset side of the WCP calculation. A pressing problem in acquisitions today is how far back in time to calculate the WCP. With the recent volatility in timber prices, sellers want to calculate the WCP using a twelve month time frame (TTM), to reflect more normal inventory in the WCP; while buyers want to look back just after three months, “T3M”, to reflect more normal current inventory.
For example, let’s say you have a lumber yard that only sells 8′ 2x4s. And let’s say you always have 100 2x4s in inventory, replenishing them as they’re sold. To simplify the math, let’s say you paid $1 for every 2×4 a year ago. You had $100 of inventory on your balance sheet. If the price of 2x4s doubles over the next 12 months to $2/stick, you carried the same number of 2x4s, but they had a higher value on your balance sheet: $200. You are probably selling at the $2/stick level, even if your weighted average for acquiring that stick was – to your advantage as a seller – lower than that.
If the WCP was calculated on a twelve-month basis, the longer-term view is to the seller’s advantage, as the seller has acquired inventory for less than the balance sheet value. (When you sell this inventory, it price arbitration is reflected in higher gross profit and higher EBITDA, even if the seller sells the same number of sticks).
That said, if the WCP were calculated on a basisThree-month (T3M), it is to the advantage of the buyer, because he acquires inventory that he will have to replace at the higher price of $2/stick.
Salespeople want a longer view; buyers want the shorter view.
During the 90-day adjustment, if the last twelve month perspective was used, the seller would likely receive an additional check from the buyer, as the WCP would normally be less than the amount of the adjustment. Conversely, during the 90-day adjustment, if the T3M outlook was used, there would likely be less variation between the WCP closing value and the adjustment value.
With lumber price volatility still in effect, even the past three-month pattern may not accurately reflect the true WCP. Ironically, with lumber prices falling from their highs, the last twelve month model may come back into favor, if it proves more accurate and fairer to buyer and seller. . That said, for deals made before prices returned to pre-pandemic levels, you’re likely to see buyers and sellers meet in the middle, calculating the WCP based on a six-month period (T6M), rather than the super-long “12” or the very short retrospective “3”.
Whatever model is agreed upon, don’t treat the WCP as an afterthought. It should be calculated by a qualified CPA on a rolling basis through closing, so there are no surprises for buyers or sellers as the purchase contract nears. Finally, getting the right WCP has financial implications that go well beyond a few dollars in both cases. As a seller, the advocacy of your investment banker is invaluable in determining the WCP, not only to undertake the difficult calculation, but also to defend the model used.
John Wagner is Managing Director at 1stWest Mergers & Acquisitions, which offers a specialized practice in the LBM sector. Contact John at [email protected]
