The Working Capital Adjustment in M&A Deals and Leveraged Buyouts

Working Capital Adjustment Definition: In an M&A or LBO deal, the Working Capital Adjustment increases or decreases the Purchase Enterprise Value based on whether the seller is above or below its Working Capital Target at deal close; this adjustment keeps the buyer’s effective price the same while changing the proceeds to the selling shareholders.

The Working Capital Adjustment is most common in acquisitions of private companies structured as cash-free/debt-free deals.

It incentivizes the management team to run the company normally without manipulating invoices, receivables, or inventory to increase its Cash balance artificially right before a deal closes.

It also reduces the need for the buyer to provide additional funding to the seller on Day 1 following the deal close – assuming the management team has responded to these incentives.

Here’s the Excel file and slide presentation that illustrate the concept:

Simple LBO Model – Working Capital Adjustment (XL)

The Working Capital Adjustment in Models- Slides (PDF)

Video Table of Contents:

0:00: Introduction

6:14: Notes and Clarifications

6:59: Model Impact

8:10: Definitions and Targets

9:15: Recap and Summary

Simple Examples of the Working Capital Adjustment

Suppose that a buyer, such as a private equity firm, is paying a Purchase Enterprise Value of $600 (12x EBITDA) for a seller.

The seller’s Working Capital at deal close is $50, but the Working Capital Target in the deal is $100.

In this case, the buyer reduces the Purchase Enterprise Value to $550, which results in only $500 of proceeds to the selling shareholders rather than $550 (assuming $50 of Cash and $100 of Debt):

In the Sources & Uses schedule, the Uses side lists this “Adjusted Purchase Enterprise Value” and flips the sign of the Working Capital Adjustment so that it appears as a positive $50 instead.

It’s a positive $50 because when the seller’s Working Capital is below the targeted WC, the buyer needs to pay for additional Working Capital to bring it up to that targeted level!

Here’s the schedule:

The buyer still pays the same effective price – $600 – but it’s split into an Adjusted Purchase Enterprise Value of $550 and Additional WC Funding of $50.

But the selling shareholders receive less – $500 rather than $550 – because they let the company’s Working Capital fall below the target as the deal closed.

The opposite happens if the seller’s Working Capital is above the targeted WC level at the deal close – such as $150 vs. a target of $100.

In this case, the Working Capital Adjustment increases the Purchase Enterprise Value to $650.

The Purchase Equity Value is now $600, so the selling shareholders receive more:

In the Sources & Uses schedule, the Adjusted Purchase Enterprise Value is $650, and the Working Capital Funding is ($50), so the effective price for the buyer is still $600:

These graphs sum up what happens due to the Working Capital Adjustment in deals:

Notes and Clarifications About the Working Capital Adjustment

Buyers set Working Capital targets in deals primarily to shift some of the risk to the sellers.

For example, they don’t want a seller to “forget” to pay its invoices right before an acquisition closes – delaying these payments would boost the seller’s Accounts Payable and reduce its Working Capital.

This is not fair for the buyer because it will need to pay these “delayed” invoices after the deal closes, which means it needs to put additional money into the company.

So, if this happens, the buyer reduces the Purchase Enterprise Value, as shown above, such that the Purchase Enterprise Value + Working Capital Funding equals the agreed-upon price ($600 in the examples above).

The seller might also order insufficient Inventory or be very aggressive in collecting its receivables, which would increase its Cash and reduce its Working Capital.

Again, buyers don’t like this behavior because it creates the need for additional funding after the deal closes.

So, they enforce the Working Capital Adjustment in deals to discourage this behavior and incentivize management to run the company normally.

Model Impact of the Working Capital Adjustment

There is no real impact on the cash flows, exit, or IRR calculation in a merger model or LBO model because the buyer’s effective price stays the same – and these models are always built from the buyer’s perspective.

In a 3-statement M&A or LBO model, you record the Working Capital Adjustment somewhere on the post-transaction Balance Sheet:

But this does not affect the Change in Working Capital in the forecasts, so the seller’s cash flow remains the same, and so do metrics like the Exit Value and the IRR.

In the simple model above, the Sources and Uses figures change slightly because the transaction fees change with a different Purchase Equity Value, but this is a tiny difference.

Working Capital Definitions and Targets

You might also wonder how Working Capital is defined and how the “target” is set.

There is no simple definition that works for all companies and industries, but Working Capital generally includes short-term, operational line items on the Balance Sheet, such as Accounts Receivable, Inventory, Prepaid Expenses, Accounts Payable, and Deferred Revenue.

You add the assets (Accounts Receivable, Inventory, and Prepaid Expenses) and subtract the liabilities (Accounts Payable and Deferred Revenue) to calculate Working Capital, as shown in the simple model above.

But there are exceptions, such as Long-Term Deferred Revenue; also, some industry-specific line items, such as “Content Assets” for media companies, may also be included in Working Capital.

Notably, Cash and Debt are almost always excluded from Working Capital because these are not operational items – and in cash-free/debt-free deals, they go to $0 and get replaced immediately after the deal closes.

The “Working Capital target” is usually based on metrics such as Working Capital / Revenue over long periods or the company’s cash collection and invoice payment policies.

For example, if it has taken an average of 45 days to collect invoices from customers over the past 5-10 years, that might be used to estimate the company’s required Working Capital based on its revenue level at the deal close.

Many software-as-a-service (SaaS) companies have negative Working Capital due to high Deferred Revenue balances.

In these cases, the buyer “should” understand the problem with a positive Working Capital target and pick something more reasonable, such as a modestly negative number that reflects the company’s cash collection and billing policies.

However, “should” is the operative word because many big companies do not properly understand this issue and will make it a negotiation point in deals.

When this happens, you should run away and find another big company to acquire your firm – or point the buyer’s acquisition team to this article.