Negotiating the Working Capital Peg
Part 4 in our month long series on Tech M&A
I stood at the craps table, energy palpable, with no idea what I was doing. I found myself out for a night on the town with my new colleagues from the PE firm I worked at. They all seemingly had PHDs in anything you could put odds on… Dice, Golf, Horses… you name it.
I, on the other hand, was relatively risk averse, and not great at games with a lot of “rules” you had to remember.
Needless to say, craps was not a natural fit. And it was a short outing.
Two rolls and everything I budgeted for “fun” that night was “gone”.
To add insult to injury, the dealer looked up with a sly smirk and exclaimed:
“You’ve gotta gas up the bus if you wanna go on the field trip.”
Demoralizing.
(Where is he possibly going with this…)
Managing working capital levels is like gassing up the bus for a field trip. In order to get a certain amount of production out of your business, you need to inject a certain amount of fuel so the bus can go where you forecasted.
And when one company buys another, it expects the bus company to still run, and not stall out, for a certain number of miles months post acquisition. Buyers look at acquiring a business like acquiring a constant stream of cash flow, accompanied by the assets required to generate said cash flow, and supported by a normal level of working capital.
The all-important (and subjective) word here is “normal”.
Here’s the rub…
Most deals close on a cash free, debt free basis. That means the seller gets to keep all the remaining cash on the balance sheet after paying off any existing debts. Why?
The buyer doesn’t care about your debt, as that was your own financing decision, which they don’t want to inherit
Caveat: They actually might if it’s a sweat heart ZIRP 3% revolver or credit facility. But that’s not the norm.
The buyer also doesn’t care about cash, as it would be tax inefficient to buy cash with cash - it would increase the purchase price and associated taxes on the transaction. They’d rather use their own.
Caveat: They probably need a few bucks in the bank account upon closing to pay for small office expenses, a few weeks of payroll, etc. But you try to keep this to a minimum. As a buyer I’d rather use my own cash, unless it’s a logistical problem.
So the working capital adjustment is everything you agree is included “in between” that’s not debt, and not cash, and needed to make sure people get paid and the business can produce a consistent stream of cashflows for a temporary period of time. (Source)
So it’s subjective. And therefore it becomes a hot point of negotiation, which can swing a deal 1% to 2%. That’s real value.
Working Capital Pegs for Technology Companies
There’s been a fair amount written on working capital pegs in businesses that sell stuff you can touch. The best piece was written by my friend The Secret CFO. While he works at companies that sell “real things” and have “real profits” (LOL) I’m going to talk about this point of negotiation specifically from the lens of software companies.
While it’s not intended to be a driver of value in the transaction, it effectively can be. But the theoretical intent is not.
“Hey, we agreed on a price for your car and that it would come with half a tank of gas. The NWC peg is an attempt to define what constitutes half a tank of gas, and if you deliver less I get made whole. But if you deliver more, I pay you for the extra gas.”
-Growth Equity Investor Friend and MM Reader
“Am I getting screwed?”
I’ve heard people describe the working capital peg as something PE guys negotiate for sport. It’s funny, but not totally true.