A Story About Working Capital

Let’s talk working capital in mergers and acquisitions. It’s funny, at SMBootcamp we always go back and forth on the best way to teach it—we’ve tried both at LIVE, depending on who’s the instructor for the session. Sam’s approach is much less academic; he teaches through his hard-earned lessons as a negotiator and a dealmaker. To put it simply “what makes this deal close”. While I, coming from the institutional investment banking background, take a more analytical approach, leaning on my trusted balance sheets and excel sheets.

Now, the academic finance and working capital can be a bit dry, so I’ll start it off with a story that hopefully resonates (maybe it just does with me):

It was my first true sellside deal at Raymond James—an industrial cleaning business based in Ohio. The transaction was what we referred to as a “franchise builder”—one that was a highly competitive pitch process with all of our major competitors taking a swing at winning the opportunity. Now we ended up winning (to this day I don’t know why), and I ended up as the lead analyst— now this had been about after 3 months as a full-time employee, and it hadn’t quite sunk in that my life was to be 70-100 hour weeks staring an excel sheet or a powerpoint with “_v95” in the title.

As a part of the sell-side investment banking process, there is something called “Management Presentations” where the Company hosts a handful of 4-hour long, in-person meetings with select buyers and the management team. Naturally, the investment bankers were present and the analysts were in charge of essentially everything. That to say, the days started with a 6am wakeup, quick shower, and off to the meeting room to “double check” the technology was working (of course, it would be the exact same setup as every previous management meeting in the room, but a managing director would never leave out the possibility of a miraculous and untimely tech failure). Then I’d head off to the front desk to ask why the coffee and bagels (that nobody would eat) weren’t half an hour early.

The meeting begins, and for the next four hours I battle resting my eyes while the private equity guys tell management that their company “reminds them of another business we invested in” or “we really care about people”— which of course every other firm had asked. Occasionally their operating partner (who may or may not have any idea about this particular industry) would chime in through the speakerphone in the middle of the table. Here and there the bankers would ask a leading question prompting management to provide a completely canned response with the words “recurring, sticky, non-cyclical, or growth opportunity”—of course, the words “Capex” were strictly off limits.

Finally, the meeting wrapped up, and we head off to a local lunch spot (always within walking distance) to give the private equity firm and management some time to “bond”. Lunch is uneventful and ends quickly.

Next up, another Management Presentation with the next private equity firm (who likely flew in this morning). The format is the exact same, quick tech setup check (again, you never know when it could miraculously fail), and we’re off to the races for another 4-hour session. By the time we’re halfway through, I’m probably on coffee cup 4 or 5. The second meeting of the day is uneventful and the conversation was eerily similar to the one from the AM block—though I might’ve let out a smirk when the CEO accidentally implied that their trucks cost money. Highlight of my day.

And… no Management Presentation is complete without the meal, so we head to dinner in a private room with fancy drinks, steaks, and some more dry and uneventful conversations (as long as Management doesn’t drink too much at least). Two long hours and the end is finally in sight; the private equity firm heads to the airport while my MD, VP, and I start walking to the hotel. I am utterly exhausted, and it’s only Wednesday. We stayed up late Tuesday to get the 60-page presentation materials into “_vF”. Of course, once the presentation is done they must be printed (most analysts moonlight as professional printers..). 24 copies, color, landscape, spiral bound, ready to fly to Cincinnati in the morning. My fellow analyst finish printing by 1am Central and uber home on the Company before I head to Cincinatti in the morning, 6am flight. Now after Management Presentations, there’s a concept called a “Check-In Bid”—in middle market M&A, the process typically goes like: IOI->Management Presentation-> Check-In Bid->LOI. And we requested the Buyer’s methodology for calculating working capital at the check-in bids. Now as an analyst here for maybe…. 6 months at this point… I certainly did not have a clue what any of that meant. But, on the walk home to the hotel my VP pulls me aside, “Zach. We’re expecting check-in bids a week from today. I need you to calculate a working capital target that we can propose at check-ins.” “Can do, sir.” I respond. Working capital something I heard in a few of my finance courses, but it didn’t really mean anything to me other than “current assets minus current liabilities”. I have no idea what to do, so I send a teams message to my associate—he would know what to do. Within the next half hour I’m on the phone with him.

Associate - “Well, do you know what working capital is?”

Me – *a brief pause* “Yeah. It’s current assets minus current liabilities”

Associate – “And do you know what a working capital target is?”

Me – “Never heard of that one before”

Associate – “Alright. So in an M&A transaction we set a working capital target. A working capital target is the amount of current assets minus current liabilities that our client has to leave in the business when this thing closes. If they deliver more, then they get a dollar for dollar increase in purchase price for the excess. If they deliver less, then the purchase price is reduced dollar for dollar. Now if they set a collar, which is basically like a band that it can be in, then there won’t be a change. We’ll figure out if we want a collar later. Let’s just focus on the target. We need to figure out a methodology where we set the peg as low as possible, so we overdeliver and they have to pay us more. That makes our fee go up.”

Me – “Yeah ok, that makes sense. So what’s the best idea for coming up with the target?”

Associate – “It’s pretty easy, should take an hour, tops. Open up the QofE, look at the balance sheet, and try a few different time periods. Let’s do a rolling TTM, rolling 6m, rolling 4m, and a rolling 3m using the balance sheet. We’re in the outage season, so the rolling 3m will probably be the highest. We’ll probably do a TTM, but figure out what those working capital numbers are and we’ll go from there.”

(Side Note: For this business, the outage season is when plants partially or fully shut down for cleaning—it’s their busiest time of the year, so they generate the most revenue).

I hung up the phone and got to work—it probably took me an hour, maybe 90 minutes. Not half bad for my first shot at coming up with a working capital methodology. It turned out that my associate was right. The rolling TTM was the lowest working capital of our methods, since the business was in the busy season. Remember, as the Seller we wanted working capital as low as possible, while the buyer wanted working capital as high as possible. The lower the working capital, the higher probability our sellside fee would go (since purchase price would go up if they overdelivered).

Now that’s my first foray into working capital in M&A transactions—and it’s a good place to start. Once you understand what it is, and who wants what, you can begin to reverse engineer strategies for it. In institutional finance it’ll often be a very simple average of 12 months, 6 months, or 3 months—then the accountants and lawyers will argue about what will and will not be included in the definition.

In small business land, it can be quite different. Information isn’t as sophisticated, sellers and brokers don’t understand the AR they generated has to go to the buyers. After all, they earned that revenue. Much like the accountants and the lawyers, you’ll want to talk to the seller and broker to find an agreeable way to calculate how much working capital they need to leave in the business. Start with calculating your averages—they’ll at least give you a rough idea of working capital requirements and fluctuations in the business. Then begin discussing what might be an agreeable approach from there. And remember, the Buyer wants as much working capital in the business as possible. The seller wants the least amount of working capital required in the business.

‍