In a previous article, we discussed Net Working Capital (NWC) and its significant role in transactions. To recap, NWC is defined as a company’s current assets minus its current liabilities. This post will address one component of NWC that is often misunderstood and mishandled in the sale of a company: deposits.
During transaction negotiations, buyers often argue deposits on a seller’s balance sheet should be treated as debt. This perspective is seldom accurate. If a seller collects deposits from customers as part of its business model, asking them to leave money in the transaction to cover these deposits, or demanding a corresponding reduction in the purchase price, would be inappropriate.
Typically, in the sale of a business, companies sell all of their operating assets and operating liabilities, while the seller retains any excess cash and settles funded debt (usually bank loans). In most transactions, there is an NWC true-up at closing where the buyer and seller reconcile changes in the target company’s NWC from the time the buyer priced the transaction.
Assets can be characterized as investments in a company and liabilities as loans to a company. While this characterization is generally accurate, it does not capture the nuances of the seller’s balance sheet, particularly the seller’s business model and how the company was built. For example, a payroll liability could be viewed as a loan from employees. However, payroll is not considered debt in the context of a transaction because it is incurred as a normal part of business operations and settled at regular intervals. Thus, payroll is almost always included in the definition of NWC. While payroll is one of the most common current liabilities on the balance sheet, there are often less common, company-specific balance sheet items that should be included as part of a company’s NWC. When a company collects deposits for products or services as part of its normal business operations, the deposits account on the balance sheet is part of the company’s NWC, not debt.
To illustrate this point, consider a hypothetical machinery company (CogsCo) that has NWC of $6,000,000, including $1,500,000 in deposits, which are received when an order is placed. For illustrative purposes, CogsCo will not experience any growth or contraction, maintaining flat sales with steady margins and NWC. CogsCo has a machine order cycle of six weeks, meaning a machine is delivered six weeks from the receipt of a deposit. At the end of week six, the machine is delivered, and any balance owed to CogsCo is paid off. Any amount in the deposit account will have been zeroed out along the way. In this example, the $1,500,000 in deposits represents six weeks’ worth of products (at most) – products at various stages of completion.
Now, consider the sale of CogsCo. Cash and debt are typically excluded from a sale, recognizing that the rest of the current assets and current liabilities are included in the NWC needed to run the business. The buyer hires a third party (usually an accounting firm) to scrutinize CogsCo’s books. This is often when the accounting firm will tell the buyer that CogsCo has collected deposits for products the buyer will have to deliver, and these deposits should be considered debt.
However, if the buyer asks the owner of CogsCo to leave $1,500,000 in cash in the company after the sale to offset the deposits, the buyer will be receiving a company with NWC of $7,500,000 (the NWC balance, including deposits, plus the cash offset). Over the subsequent six weeks, the buyer will be collecting deposits for new orders and delivering machines that were in various stages of completion when the buyer acquired CogsCo. Six weeks after the sale, the buyer will have delivered all the machines for which a deposit existed at the time CogsCo was purchased, and the current deposits account will represent only machines sold under new ownership. At this point in time (six weeks after the sale), the deposit balance for CogsCo will be $1,500,000, with NWC of $6,000,000, plus the buyer will still have the additional $1,500,000 in cash it required the owner of CogsCo to leave behind. In other words, the buyer will have all the NWC it needs to run CogsCo, plus an additional $1,500,000 in cash. In this example, asking the seller of CogsCo to leave $1,500,000 in the company after the sale would be the equivalent of asking the seller to decrease the purchase price of the business by $1,500,000.
To further clarify this point, consider the scenario where a buyer acquires CogsCo with no deposits on the balance sheet, and everything else remains the same as above. The buyer would be acquiring a company with no backlog and would not be collecting any cash from customers, except new deposits, for at least six weeks. Without deposits, the buyer of CogsCo would only receive sales generated under its new ownership. This is not the case when the buyer acquires CogsCo with deposits on the balance sheet (i.e., sales backlog). The buyer will collect cash during the first six weeks post-transaction from sales under the previous owner, based on the NWC (including deposits) value at closing.
Many other advisors or investment bankers may not provide proper guidance to their clients on this issue, either because they do not understand the subtleties or do not see the value in making the effort for the seller. NWC is often negotiated after the buyer and seller have executed a Letter of Intent (LOI), requiring the seller to work exclusively with that buyer, which can impair their negotiating leverage. Having an investment banker who understands all the nuances of working capital and is willing to advocate on the client’s behalf throughout the entire transaction process is critical to maximizing sale proceeds.
If you are considering selling your business and would like to discuss NWC or the sell-side process, please contact us at ib@crewe.com.