When discussing Business Value there is a fascination with the “profit multiple” calculation. But the value of working capital, and what is to be done with that working capital during a transaction, demands equal attention, discussion and clarity from both buyers and sellers.
The purchaser expects that by paying the value derived by applying the multiple to the maintainable earnings they are paying for all the assets required to run the business. These assets include Plant, Property & Equipment (PP&E), Staff, Customer Contracts, Intangible assets such as the Customer and Contractor data bases and sufficient Working Capital to run the business.
It is often joked that recruitment agencies don’t have many “assets”; that their business value is in the staff that walk out the door each evening. Certainly recruitment agencies do not have significant investment in Fixed Assets but the current assets; cash, debtors and prepayments and current liabilities; amounts owing to employees, suppliers, tax obligations and holiday and long service obligations to employees will be significant for all agencies.
In most cases if you provide temp and contract services then you will have a constantly changing and complex balance sheet that reflects both the obligations outlined above together with your cash and amounts owed by clients. This is then made more complex by the manner in which you fund this working capital – self funded, business overdraft, or some form of debtor financing.
Related: Working Capital Assessment is Complex and Impacts Deal Value
The big issue for small and medium recruitment agencies is what happens to the working capital when the business is sold, as the value of the working capital can vary from a small amount to many millions of dollars in value.
Net working capital (NWC) is generally defined as current assets minus current liabilities.
NWC often varies over the course of a financial year so it is common to calculate the average NWC over the year. This average then becomes the target NWC that the buyer expects to be left in the business. At completion any surplus over the target level becomes an addition to the purchase price and any shortfall will become a reduction to the purchase price.
Lawyers who draft NWC adjustments must have a very clear understanding of the target company’s balance sheet since the target company’s balance sheet is the starting point to determine current assets and liabilities.
This is an important negotiating point for small to medium recruitment agencies. The mechanisms will vary depending on the sale structure – an asset (or “business”) sale or a share sale.
In some instances all excess working capital is paid out to the seller. That is, the cash and value of invoices (when paid), less any liabilities and staff entitlements is withdrawn by the seller.
It is becoming more common that the seller will be asked to leave in the business the minimum working capital required to operate the business. In this instance only the excess working capital will be withdrawn by the seller.
Most M&A agreements for private companies include a purchase price adjustment provision for net working capital. These common provisions exist because when a buyer values a target company, the buyer’s valuation is usually based on a snapshot of the target company’s financial condition on a specific date. And since time passes between that date and the actual closing date when the buyer acquires the target company, a purchase price adjustment might be necessary to reflect changes in the target company’s updated financial condition. This net working capital adjustment is important when determining a company’s value.
Determining NWC can slow down deal negotiations and can even end the deal entirely, so understanding and clearly defining the new working capital for a transaction is crucial. To avoid disputes down the road, the parties should have a clear understanding of the legal and accounting principles involved, and then seek to define NWC as much as possible. The time and effort put in by both parties to understand and define NWC during the deal will help reduce any disputes.
HHMC Global provides advisory services to the recruitment and staffing industry and is best known for its work on M&A transactions. HHMC is based in Australia and works with clients globally. To discuss your business future contact Rod Hore or Richard Hayward.