How Working Capital and Leverage Affect a Merger and Acquisition Deal

By Nicholas Florio

In my many years of assisting on merger and acquisition transactions, there are two elements that have caused the most confusion and the most conflict between both buyer and seller, namely, the requisite amount of working capital that is required from a seller, and what it really means to deliver a “debt free” balance sheet.

While these two issues are different, they are tied together in determining what a company is really worth, and what expectations a seller ought to have about the true value of their company.  For starters, if you’re thinking your company ought to simply be worth 5 or 6 times EBITDA (a formula often used for valuing a strong company) you’re missing some other very essential components of that valuation.

The “true value” of your company in the mind of the buyer also needs to provide for a requisite amount of working capital so that a buyer can run the operations of your former company the very next day, in a seamless manner.  That said, what does this really have to do with a multiple of EBITDA?  The answer is – absolutely nothing!  These fundamental issues, while mutually exclusive, need to be tied together in order to ascertain what FAIR MARKET VALUE really is.

This is the first step towards bridging the “expectation gap” between buyer and seller in terms of the value of the underlying business, and why it is a highly contested matter.   Emotions get involved when sellers don’t adequately understand that to get paid what they believe is a fair price for their company, they also need to give back a significant amount of those proceeds in the form of working capital.  The trick is in measuring just how much working capital is required. ..and that is where the second issue of leverage or debt enters the equation.

Let’s assume a company has $1,000,000 of EBITDA and that for argument sake it may be worth a six multiple or $6,000,000. The buyer needs the seller to leave working capital on the table so that the business can continue to operate the day after closing. The company may be worth $6,000,000 to the buyer only if adequate working capital is left in the company.  The measurement of working capital is more scientific than arbitrary and should be able to be reasonably calculated by either party, using similar measurement standards.  If the parties can agree to the basic way in which working capital will be calculated, this will go a long way towards moving the deal forward, reducing or eliminating surprises, and diffusing the emotions that tend to override the logic needed to value a business.

My personal preferred method of determining working capital includes utilizing the company’s actual accounts receivable turnover statistics.  In this process you would calculate how quickly the business is collecting its accounts receivable.  In today’s economic climate, that may be on average about 60 days!  In my calculation, that would require the seller to leave 60 days worth of working capital on the table for the buyer.  At this point, if the buyer and seller can agree that 60 days of working capital is a sufficient amount, the rest of the task becomes mathematics and mechanical. Leave that to the accountants!

The second issue of leverage comes into play for temporary employment companies that have financed their growth and leveraged the company.  If you have built a business using the bank’s money instead of your own equity, then delivering a debt free balance sheet will be painful for you.

This is again a somewhat fundamental concept, but yet so many sellers get emotionally hung up on how this works, because it has a direct impact to the amount of proceeds they will actually receive.   From the buyer’s perspective, they don’t care how you built your business or whether it was with your money or the bank’s, they just want your company debt free, and free of all liens and encumbrances.  The onus of repaying the bank falls on the seller, and where does the seller get this money from?  If you thought by liquidating the accounts receivable, then you misread the first part of my article!  The accounts receivable will make up the major portion of the working capital that needs to be delivered.  So the correct answer is the bank debt gets repaid straight from the proceeds the buyer is paying to you!

What a reality check!!  Now all along you thought your business was worth $6,000,000 and here we are having to pay the bank back first from those proceeds, and then also having to also deliver sufficient working capital to the buyer on top of that… well YES !!  The purchase price minus debt repayment and the delivered working capital is what your company is really worth to you when you sell. When the seller does not understand this principle, buyers and sellers can’t get past agreeing on the basic value for the business.  The truth is that if you find yourself getting emotional about the value of your business, it’s probably because you never really understood how it was being valued.  I would encourage you to take a moment and apply these simple mechanics to your circumstances and gauge your own “expectation gap” prior to engaging a merger and acquisition advisor to market your company for sale.

Nicholas Florio is a CPA and partner at Citrin Cooperman & Company, LLP.  He can be reached at 221-697-1000 or at nflorio@citrincooperman.com.

Copyright 2011 Nicholas Florio. All Rights Reserved.