At the closing of an acquisition, the merchant banker representing the seller calculates the working capital peg (WCP), a figure resulting from current assets less current liabilities, with some exclusions. (A good investment banker actually models WCP continuously for the seller well in advance of closing, but WCP peg is set at acquisition close, using the very last numbers on the balance sheet.)
Assuming the business is sold on a cashless / debt-free basis, let’s take a look at how the peg to working capital is determined, as there are idiosyncratic exclusions and inclusions when using the very common agreement format without money / debt free. On the current asset side of the general ledger, the working capital peg will exclude “cash and cash equivalents,” which will all go to the seller. Current assets include inventory, accounts receivable and most prepayments. For current liabilities, the WCP will include accounts payable and most accrued liabilities. By subtracting these current liabilities from current assets, you determine the WCP. In almost all transactions, there is also a 90-day “fit” adjustment after closing. Note that the inventory value appears as an asset in the WCP calculation. A pressing question in acquisitions today is how far back in time to calculate WCP. With the recent volatility in timber prices, sellers wish to calculate WCP using a rolling twelve month time frame (TTM), to reflect a more normal inventory in WCP; while buyers want to look back on the past three months, “Q3M”, to reflect a more normal current inventory.
For example, let’s say you have a lumber yard that only sells 8 ”2x4s. And let’s say you always have 100 2x4s in inventory, restocking them as they are sold. To make the math easier, let’s say you paid $ 1 for every 2 × 4 a year ago. You had $ 100 of inventory on your balance sheet. If the price of 2x4s doubles over the next 12 months to $ 2 / stick, you are carrying the same number of 2x4s, but they have a higher value on your balance sheet: $ 200. You’re probably selling at the $ 2 / stick level, even though your weighted average for acquiring that stick was, to your advantage as a seller, lower than that.
If WCP were calculated on a rolling twelve month basis, the longer-term view is to the seller’s advantage, as the seller has acquired inventory for less than the value shown on the balance sheet. (When selling this inventory, this price arbitration is reflected in a higher gross margin and higher EBITDA even if the seller sells the same number of sticks).
However, if the WCP was calculated on aThreeon a monthly basis (T3M) this is to the buyer’s benefit as they acquire inventory that they will need to replace at the higher price of $ 2 / stick.
Salespeople want a longer view; buyers want a shorter view.
During the 90 day adjustment, if the last twelve months perspective were used, the seller is likely to get an additional check from the buyer, as the WCP would normally be less than the adjustment amount. Conversely, at the 90-day adjustment, if the T3M outlook was used, there would likely be less variation between the WCP closing value and the adjustment value.
With lumber price volatility still in effect, even the pattern for the past three months may not accurately reflect the true WCP. Ironically, with lumber prices falling from their all-time highs, the pattern of the past twelve months may come back in favor, if it turns out to be more accurate and fair to both buyer and seller. That said, for deals made before prices return to pre-pandemic levels, you will likely see buyers and sellers meeting in the middle, calculating WCP on a rolling six-month (T6M) basis, rather. than on the long “12” or the very short “3” retrospective.
Whatever model is agreed upon, don’t treat WCP as an afterthought. It should be calculated by a qualified CPA on a rolling basis until closing, so that there are no surprises for buyers or sellers as the purchase contract nears. Finally, setting up WCP properly has financial implications that go well beyond a few dollars in either case. As a salesperson, the advocacy of your investment banker is invaluable in determining the WCP not only to undertake the difficult calculation, but also to defend the model being used.
John Wagner is Managing Director of 1stWest Mergers & Acquisitions, which offers a specialized practice in the LBM sector. Contact John at [email protected]