How I thought I looked
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.
Live footage of a deal falling through
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.
Most people are trying to do a deal in good faith, and just want the tank of gas they were promised.
Where everyone gets wrapped around the axle is when people try to get tricky and take money from the seller’s pocket with it.
In a software business, for the most part, NWC isn’t a massive problem. The most simple software businesses are basic Accounts Receivable and Accounts Payable.
But if I was buying your sweater company, I don’t want you to deliver it to me with no sweaters right before Christmas, because then I’d have to turn around and put cash into the business to buy more inventory… and that’s not in the spirit of the deal.
“When I design a peg, I basically go through the entire balance sheet and kind of split it up - this is cash, this is debt, this is Net Working Capital, and this is just part of the “other stuff” that I get (PPE, goodwill, intangibles, etc.). Idea being that someone can’t pull the levers to my detriment without a corresponding offset in value.”
-Growth Equity Investor Friend of the Newsletter
Where it can potentially get more complicated in tech deals is when there are multi year contracts and a high level of deferred revenue involved.
Unlike companies with physical products, tech companies often receive payments upfront for services to be delivered over time. How this deferred revenue is treated in NWC calculations can significantly impact the transaction value.
Including deferred revenue in NWC is typically what the seller wants, but that’s not always fair. If you collected $5M of cash for a 3 year contract, and you get all of the benefit of that cash at close (cash-free deal), that’s not fair to the buyer - they still have to deliver on that contract for the next 3 years - especially if it’s a low gross margin business.
The opposite of that is a buyer asking for deferred to be a debt-like item, so a dollar-for-dollar deduction to equity value, which also isn’t entirely intellectually honest.
So let’s take a five year contract. At time of acquisition, there are three years left on the contract. How should we treat it?
Well, it depends if the cash has been collected or not. If not, no big deal, because I’m going to get it. And I can use that to offset my cost to serve.
If it has been collected, the investor may argue it’s a debt like item for two years. But most often you’d settle at cost of service. So if you’ve collected $5 million of cash for a 5 year contract that’s recognized pro ratably, and your gross margins are 80%, you’d want a 20% x $3M = $600K adjustment to purchase price to service that contract.
Where does the confusion stem from?
Establishing a NWC peg can be confusing for the following reasons:
Net Working Capital in general is not well understood, so it feels like an area someone cold screw you if you’re not careful.
Founders don’t always look at Net Working Capital as an investment, which it is. You can’t run the business without it, and it’s a “store of cash”, so the investor should expect an appropriate level of it when they receive the business.
It does drive dollar for dollar changes in value… but it’s not SUPPOSED to be a driver of value. It’s just meant to protect the buyer (and seller) and make sure the business is delivered with an appropriate amount of NWC. But there is money on the line.
Getting More Specific - “Accounting vs Real Life”
To drill into a point we made earlier, working capital in the strict accounting sense isn’t how it goes down in reality.
Cash is excluded - whereas the accounting definition includes all working capital accounts
Because most businesses are purchased on a cash free, debt free basis, the seller gets to keep the cash in the bank account after paying down any remaining debt
Aged receivables - The buyer may omit any accounts receivables balances aged 90 days or more, because they don’t think they’ll actually be collected once the transaction closes… so why pay for it
Obsolete inventory - if you can’t use it, why buy it (Source)?
What’s most important to include and consider is payroll.
Accrued Salaries and Wages: These are the amounts owed to employees for work performed, but not yet paid. They are recorded as current liabilities.
Accrued Bonuses: If employees are entitled to bonuses that have been earned but not yet paid, these are also included as current liabilities.
Accrued Benefits: This includes vacation pay, sick leave, and other employee benefits that have been earned but not yet used or paid.
That’s why a working capital adjustment exists - it bridges the Accounting treatment of working capital with the “reality” of the situation.
How do we settle up?
Source: Baker Tilly
Setting the Peg: The working capital peg is usually based on an average of historical working capital levels over a specified period (e.g., 12 months) to smooth out seasonal fluctuations and one-time events.
Source: Baker Tilly
At Closing: The actual working capital at the time of closing is compared to the peg. This comparison doesn’t usually happen for 60 to 90 days after the company changes hands. There’s too much going on the day of, and the buyer needs to get in there, figure out what’s going on, and come up with their “day one” financials
Adjustment: There’s an amount of cash kept back in escrow (let’s say it’s $500K for this example). If the final working capital balance is $100K lower than expected, the seller receives only $400K. If it’s $100K higher, they receive $500K plus another $100K check from the buyer.
Ultimately, how do you get comfortable with the adjustment? You can cap it with a collar (e.g., adjustment can’t be more than $[x] dollars in either direction.
OK, but tell me the horror stories, those sound fun
Once again, there isn’t a ton that can go wrong in software if you get deep into the multi year contracts. It usually goes off the rails when there’s physical inventory that the owner can liquidate in-between signing the LOI and closing.
You can imagine a fictional crazed owner, trying to sell off every sweater and sewing machine in his factory before the deal closes to get some extra cash.
But in reality, here are the “big picture” areas it can go awry:
Software Licenses, Cloud Costs, and Subscriptions Inventory: The value and renewal terms of any pre-purchased software licenses and subscriptions should be reviewed and included in NWC calculations, ensuring no hidden liabilities are transferred to the buyer (and services don’t shut off over night)
Accrued Compensation: Do employees have any big year end bonuses coming up?
Retention Bonuses and Severance Packages: Any planned or contingent employee-related costs must be included in NWC calculations to ensure the buyer inherits a fully operational team without unexpected financial burdens.
Aging AP: It would be really bad if a big enterprise customer doesn’t pay on time, as expected, or at all.
Professional Services: Did any customers sign up and pay for a professional services / implementation that the buyer now has to complete?
Final Advice
If you are the seller, let the buyer make the first working capital proposal. Don’t throw the first number out there.
If you are the buyer, make sure the seller has burdened the COGS appropriately.
Just be a good person.
