The treatment of working capital represents one of the most nuanced yet critical aspects of deal structuring. While the standard accounting definition of working capital is current assets - current liabilities, its application and implications in M&A transactions diverge significantly from this definition.
Here's what you need to know:
Understanding the Equity Bridge Distinction
In standard valuation contexts, working capital adjustments are typically excluded from the
equity bridge calculation. This is because it is considered an integral part of normal operations.
The enterprise value assumes a normalised level of working capital, with any temporary fluctuations expected to revert to historical means over time. However, in M&A transactions, it becomes a distinct component of the equity bridge. It represents a specific negotiated term that directly impacts the final purchase price. This fundamental difference arises because one party could receive a windfall at the expense of the other if working capital at completion differs materially from a 'normalised' level.
To address this, M&A transactions establish a 'target' or 'peg' working capital level that serves as a benchmark.
Any deviation from this target at closing results in a euro-for-euro adjustment to the purchase price - either an additional payment by the buyer for excess working capital or a reduction in price for a working capital deficit. This mechanism ensures neither party gains nor loses from temporary fluctuations in working capital at the point when the deal is completed.
‘Peg’ Problems in Practice: Value Transfer Cuts Both Ways
Consider a manufacturing business valued at €500 million.
In a standard valuation context, if working capital temporarily spikes due to seasonal inventory build-up, this wouldn't typically trigger any adjustment to the equity value. This is because it's considered part of normal business operations.
However, in an M&A context, if the parties agree to a target working capital of €50 million (which appears too low given the seasonal nature of the business) and the actual working capital at closing is €58 million, this results in an extra €8 million payment to the seller through the completion accounts process.
The low peg effectively transfers value to the seller. The buyer is paying extra for a level of working capital that should have been considered normal for the business.
Beyond ‘Normalised’ Working Capital
One frequent source of tension in M&A negotiations stems from the parties' different perspectives on what constitutes “normalised" or “run-rate” working capital.
These terms are pejorative and really beg the question: how the working capital should be defined?
Some parties advocate for using recent historical averages, but as we discuss below, this approach can also lead to asymmetric outcomes.
This highlights why working capital adjustments in M&A need careful consideration. Often becoming a key point of negotiation in transaction documents.
The Strategic Art of Setting the Working Capital Peg
We've established why working capital adjustment in M&A transactions is crucial. The next challenge is a different conundrum:
Determining how working capital is defined and how to set the Peg so that neither party gains an unintended windfall at completion.
This requires careful examination of some of the key items that receive different treatment in M&A working capital calculations compared to standard accounting practice:
Operating Cash
Despite being a current asset in standard accounting, operating cash is typically excluded from M&A working capital calculations.
This is for several compelling reasons:
First, unlike other working capital items that naturally fluctuate with business operations (such as inventory or receivables), operating cash requirements tend to be relatively stable and specific to each business's operating model. For example, a retail business might need minimum till floats. These requirements are better addressed through specific provisions in the Sale and Purchase Agreement (SPA) rather than through working capital mechanics.
Secondly, including operating cash in working capital calculations would create needless complexity. It would require frequent reassessment of what makes up 'normal' operating cash levels versus surplus cash. This distinction becomes particularly critical in M&A transactions, where it represents a significant negotiating point.
Buyers typically seek to maximise the amount classified as operating cash since this is excluded from working capital calculations and therefore doesn't trigger an additional payment at completion. Conversely, sellers prefer to cut operating cash and classify more cash as surplus, which they can either extract before closing or need the buyer to pay separately.
The solution in most M&A transactions is to handle operating cash through separate mechanisms in the SPA, typically establishing a minimum cash requirement that must remain with the business post-completion. This approach provides clarity for both parties and avoids conflating operating cash requirements with working capital fluctuations.
Fixed Assets Held for Sale
Under standard accounting practice, fixed assets held for sale within the next 12 months are classified as current assets. However, in M&A working capital calculations, these items are typically excluded despite their accounting treatment.
Including them would artificially inflate the working capital target, creating an unintended advantage for the buyer who would receive both the working capital adjustment and the future proceeds from the asset sale. This exclusion from working capital definitions in M&A reflects the economic substance of the transaction.
These assets are not part of the normal operating cycle, and their anticipated liquidation represents a one-off cash event that should be addressed separately in the SPA.
Short-Term Cash Equivalents and Investments
These items are typically excluded from M&A working capital calculations, being treated instead as surplus cash. While standard accounting includes them as current assets, M&A practice recognises them as excess liquidity beyond operational requirements. This treatment reflects the reality that such investments could be liquidated without impacting core operations. These items are typically addressed separately in the SPA as part of cash and debt calculations, ensuring the working capital mechanism focuses purely on operational items.
Short-term Debt (Falling Due Within 12 Months)
While a current liability in standard accounting is excluded from M&A working capital calculations. This exclusion prevents double-counting, as such debt is handled within the net debt calculations in the equity bridge. This approach provides clearer visibility into true operational working capital needs by separating financing decisions from operational requirements. The treatment of debt, regardless of maturity, is typically addressed in separate debt-related provisions of the SPA.
Items with Ambiguous Classification
Several items, while technically current liabilities under standard accounting treatment, can be treated as either debt-like items or working capital, requiring careful consideration and explicit agreement between parties. Deferred revenue is a prime example and often one of the most heavily negotiated areas since buyers will seek to treat it as debt (and thus deductible from the price) while buyers will seek to include it as part of working capital.
Other examples include customer deposits and extended payment terms beyond normal trading cycles. The treatment of these items should be explicitly addressed in the SPA to avoid disputes during closing adjustments.
Aligning Periods: The Million-Dollar Timing Question
Once the definition is settled, selecting the reference period for calculating the target working capital level becomes critical - and potentially contentious.
The choice of reference period can materially impact the final purchase price, potentially shifting millions in value between buyer and seller.
Several complex questions need to be addressed:
Should the reference period align with the timeframe used in the valuation? If so, what assumptions does this make about the 'normal' level of working capital needed to support the business? When the valuation relies on forecast rather than historical EBITDA, the complexity multiplies - how should parties approach working capital benchmarks for future periods?
The timing of completion itself introduces extra challenges. It often fluctuates a lot within monthly reporting cycles. How should parties address scenarios where completion occurs mid-month rather than at month-end?
The answers to these questions can have material financial implications for both buyer and seller.
Separate Consideration: Future Funding Requirements
While the working capital target in the
SPA focuses on ensuring a fair transaction at completion, buyers must separately analyse how working capital requirements will change post-completion. For example potential operational improvements or expansion.
These forward-looking considerations, while crucial for business planning, should not influence the working capital target mechanism in the SPA. Because they represent buyer-specific plans rather than the business's inherent working capital needs at completion.
This analytical rigour helps ensure the working capital target serves its primary purpose: facilitating a fair transaction where neither party gains an unintended advantage through the timing of completion or the manipulation of working capital components while maintaining alignment with the valuation basis of the transaction.
The complexity of the working capital adjustment in M&A extends far beyond basic accounting principles, touching every aspect of deal execution.
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FAQ
What is normalised working capital in M&A?
Normalised working capital in M&A is the average level of working capital a business needs to operate efficiently, adjusted for non-recurring or unusual items. It ensures a fair baseline for valuation and purchase price adjustments during a transaction.