As any business enters the sales process or looks to acquire another business, the buyer and seller will go to great lengths to agree on a purchase price. However, once a deal has been struck, there is an additional nuance which can cause each party consternation and may require additional negotiation. That final piece is determining the working capital peg.
Many privately held business owners may not be familiar with the mechanics of the working capital peg or exactly how it works. Below we will address four key questions that provide an overview of the working capital peg and its importance in M&A transactions.
What is working capital?
Working capital generally represents a business’s current assets less its current liabilities. Examples of current assets used to determine a working capital peg are accounts receivable, inventory, and prepaid expenses, whereas examples of current liabilities are accounts payable, payroll-related liabilities, and other current accrued expenses. The net amount between these two categories comprises a business’s working capital.
Why is working capital important in an M&A transaction?
When a buyer and seller agree on the principal terms to transfer the ownership of a company, there is typically a month or two between the date an agreement is reached and the actual closing date. The working capital peg is used to ensure a reasonable amount of working capital is being transferred between parties as of the closing date.
From the buyer’s standpoint, an appropriate level of working capital should be contained within the business on the closing date. This will eliminate the concern that the seller will leave too little working capital by aggressively collecting receivables or not carrying the appropriate levels of inventory.
Conversely, the seller does not need to worry about leaving too much working capital in the business. For example, if accounts receivable collections are a little slow leading into the transaction’s closing date, they do not need to be concerned they are leaving “money in the business” in the form of receivables.
How is the working capital peg determined?
The peg is usually set based on the company’s actual working capital levels over a twelve or eighteen-month period leading into the agreement date. Both parties will utilize the same set of financial information and agree upon a working capital peg, which could simply be the average level of working capital over the specified period.
What does this mean at closing date?
If the actual working capital at the time of closing is lower than the working capital peg, it may require the seller to fund the related deficit. On the other hand, if the delivered working capital is higher than the working capital peg, the buyer may be required to fund the seller the excess. For example, if the agreed upon working capital peg is $5 million and the actual working capital delivered at closing is $5.1 million, then the seller will be entitled to an additional $100K because they left “too much” working capital in the business. As you can probably imagine, if the working capital peg was incorrectly set, it could spell disaster to one party or another.
It is important to establish an appropriate working capital peg because it can mean real dollars to either party involved. Despite the simplicity of the working capital peg described above, it is very common for buyers and sellers to utilize third party advisors to help with peg determination. Navigating an M&A transaction can be stressful enough for privately held business and having an expert assist in the evaluation of the financial data used in developing the working capital peg can provide a sense of security.
If you would like to learn more about working capital in a deal and how it may apply to your business, please do not hesitate to contact us.