Working Capital Target

/ June 12, 2019/ Forecasting & Cash Flow

A working capital target (or working capital peg) is a point of negotiation during acquisition due diligence. But what exactly is a working capital target?

Working Capital

Let’s first review the definition of working capital: current assets minus current liabilities. But working capital has importance beyond the accounting definition.

It provides the liquidity needed to operate the business on a day-to-day basis (e.g., cash for employee paychecks).

Acquisitions often exclude cash and interest-bearing debt from the working capital calculation. Most acquisitions are performed on a “cash free, debt free” basis. This means the seller keeps the cash and uses sale proceeds to pay off existing debt.

A buyer generally does not want existing debt. The buyer wants to choose how to finance the purchase, whether it be through cash, debt, or equity.

Target

All businesses need some level of working capital to fund daily operations. Buyers want to maintain this normal level of working capital. A buyer does not want to write one check to acquire a business and then immediately write another to make payroll or pay bills.

To ensure this doesn’t happen, a working capital target is set. The average working capital level for the trailing 12 months (TTM) often sets the target.

The final working capital balance is usually determined 60-90 days after closing to allow transactions to settle. This amount is then compared to the target. A missed target reduces the purchase price dollar-for-dollar. If the target is exceeded, there is a dollar-for-dollar increase.

A target assures the buyer that when they buy the business they have paid the full price. They don’t need to commit more money to ensure liquidity.

The target also prevents the seller from pulling the cash out of the business through bank withdrawals or by speeding up collections.

Because of the impact the working capital target has on the purchase price, the target level is often a key item in acquisition negotiations. Buyers and sellers both seek to influence the target by defining what is included or excluded, as well as whether any adjustments should be made for “one-time” items.

The goal of these target negotiations is not to favor one party or the other, but rather to settle on a fair price for both parties.

Share this Post

Leave a Comment

Your email address will not be published. Required fields are marked *

*
*