Business sales – Net Working Capital and cash adjustments

Looking at selling your business? If you think that agreeing the business value is the hard part, the question of purchase price net working capital adjustments and how much cash to leave in a business at a sale can be a major source of tension towards completion.  In this article we address key concepts and questions in a business sale:
  • What is the problem?
  • What is Total Enterprise Value?
  • What is Equity value?
  • What are business sale purchase price adjustments?
  • Is all cash surplus?
  • How much minimum cash to leave in?
  • Who pays for minimum cash – buyer or seller? 

What is the problem?

If you’ve read a broker report or looked at some analytics of public listed companies, you will see that that all net working capital is included and all cash is treated as a “surplus asset” when reconciling enterprise value to market capitalisation, (equity value).  For example:
$A Million Apple Inc.
(AAPL)
Harvey Norman Holdings
(HVN)
G8 Education (GEM) ASX Small Ords (^SXO)
  Tech Juggernaut Retailer (mostly) Child care owner operator Diverse, and not that “small”
Total Enterprise Value (TEV) 1,359,869.7 5,452.8 1,690.1 n/a
Plus Cash & Short Term Investments 114,459.5     150.9 56.9 n/a
Less Debt (160,959.5) (832.6) (371.8) n/a  
Market Capitalisation (EV) 1,313,369.7   4,742.5 1,375.2 n/a
         
Cash % to Revenue 30.9% 7.0% 2.0% 9.1%
Cash % to EBITDA 103.6% 28.4% 38.8% 67.2%
NWC % to Revenue 5.0% 44.5% 16.1% 13.5%
EBITDA / TEV 12.3x 10.1x 11.4x 12.5x
(Source S&PCapIQ June 2019 and MSV analysis)

The questions is, if I was to buy any of the above today on a cash free debt free basis, would I be happy paying the Total Enterprise Value (TEV) and not leaving any cash in the business?  Will I get a nasty surprise and have to inject cash on day 1 to pay expenses?  Is there actually some level of minimum operating cash that is really part of net working capital and TEV?

There are a couple of concepts to cover before we get to the details about net working capital and cash adjustments.

What is Total Enterprise Value?

Total Enterprise Value (TEV) is the value of all the businesses operating assets.  The operating assets are all the assets needed to generate the earnings (or future cash flows) of the business.  Operating assets typically include:
  • Net Working Capital (NWC being: Debtors, Stock, Creditors & Accruals)
  • Property, Plant & Equipment
  • Intangible assets – formal trademarks, brands, patents, licenses and “goodwill”.  Goodwill includes, customer relationships, workforce, locations, know-how etc.  
Note that cash is not included in the above list. 

In private business valuations or sales, TEV is usually estimated first.  This is because there is no market share price for valuing the equity directly.  TEV is typically estimated as a multiple of earnings (e.g. x Earnings Before Interest tax, depreciation or amortisation - EBITDA) or through a Discounted Cash Flow (DCF) technique.  
In very small cash trading type businesses the TEV might be broken down to its components and negotiated separately – e.g. stock at value, plus PP&E plus a smaller multiple of revenue or earnings for “goodwill”.  
Irrespective of how it is determined, the TEV should bear some relationship to the earnings and cash flow the business will generate.  After all, that is the point of owning a business – to get the future cash flows and make a return on investment that is better than alternate investments with similar risks.  

What is the Equity Value?

The Equity Value (EV) is the value of the shares / equity holders’ interests in the company.  The difference between TEV and EV is due to surplus assets like cash and debt as shown in the table above.  
The Equity Value for a private business is derived by adding surplus assets and deducting debt.  A surplus asset, is any asset you don’t need to generate future earnings.  Cash of itself does not generate future earnings (other than interest) so is regarded as a surplus asset.  

Debt is deducted as debt holders have to be paid first from the business assets and cash flows before equity holders.  The difference between TEV and EV is simplest to understand as: TEV is the price you can sell your house for.  EV is what you get after you pay back the bank.  The more debt you have, the less EV you have.  
In the case of public companies, the EV is a traded price for the shares.  So in the examples above, unlike private companies, we work backwards from Market Capitalisation so as to derive Total Enterprise Values.

What are business sale purchase price adjustments?

When a business is being sold as a going concern, typically the vendor and purchaser negotiate initially based upon TEV which is implicitly on a cash free debt free basis.  There is usually some sort of EBITDA multiple that frames the valuation negotiation, with the buyer in particular considering how they will fund the transaction (e.g. with debt borrowing capacity as a multiple of earnings) and what the future return on investment will be.  

Ultimately at some point in the negotiations, a TEV will be agreed.  Leaving aside tax considerations, the vendor will usually want to exit the business with all of the cash and the buyer will want the vendor to pay out the debt or debt like items (e.g. excessive leave provisions, prior period income taxes, unearned income, dividends payable or unpaid present entitlements).  To the extent that any of these amounts are still present at completion, then the purchase price will be adjusted up for any cash and down for any debt on a $1 of $1 basis.  

So far, this should be entirely consistent with the reconciliation between TEV and TV.  

What of NWC?  As noted above NWC is assumed to be included within the TEV and does not form an adjustment to value.  This is because TEV assumes all assets are needed to operate the business and generate the earnings on which the valuation was agreed.  All the assets includes NWC.  
The problem is, as any business owner will know, NWC has a tendency to move around.  This movement can be due to:

  • Timing of debtor receipts.  For example, if a major customer pays just before completion, then this will appear as cash and be taken out by the vendor.  However the buyer will then start with a “lower than normal” NWC.  
  • The inverse is also true of creditor payments.  A vendor could delay paying creditors so as to retain cash paid out to him at exit, but the buyer will be left with a “lower than normal” NWC.
  • A seasonal build up in inventory – e.g. retailers typically build up inventory before XMAS.  If the vendor delays this, a buyer in November will be in for a nasty shock come December.  
  • Impact on accruals of quarterly or irregular payments (e.g. taxes, subscriptions).
  • Style and operating cycle of the business: e.g. a  commercial bakery that mostly sells to food service on a cash on delivery basis, but purchased raw materials on 60 day terms.  Therefore its normal NWC balance would be negative.
  • Impact of deferred revenue, work in progress (WIP) and accounting adjustments.  Subscription businesses or builders typically bill the initial instalment in advance (and costs as WIP). Revenue and expenses are only brought to account per stages of completion.  The offset to deferred revenue will either be sitting in cash or debtors.  Deferred revenue can therefore be treated as part of NWC or as a debt like item or a bit of both.  
Consider the companies in the above table.  They have roughly similar earnings to TEV multiples of say 10.1x to 12.5x.  However, each has very different NWC balances as they have different business models from a tech/brand juggernaut, retailer and service provider.  Not surprisingly Harvey Norman holds a large NWC balance due to inventory.  

Given that TEV includes NWC, we would expect each business to come with a “normal” level of NWC appropriate for that style of business.  In a sale process this is typically dealt with by setting a Target NWC for determining the TEV sale price, and then comparing the Target NWC with the actual delivered NWC on the completion date.  A $1 for $1 price adjustment is then made as:
  • Buyer pays difference if Completion NWC > Target NWC
  • Buyer gets discount for difference if Completion NWC < Target NWC.  
Setting the Target NWC therefore becomes a very important part of the acquisition and due diligence process.

The first issue is to agree what is and is not included in the definition of NWC.  There are several schools of thought, however, it should be those balance sheet items that are likely to generate or consume cash in the short term at their realisable values.  Under this premise, you can usually exclude non-cash accounting items like deferred tax assets / liabilities and employee provisions.    

There are all sorts of Target NWC setting methods used including: 12 month financial year historical averages, rolling 3-12 month averages, average trading terms days or count backs, NWC forecasts per a three-way forecast model.  As for any valuation, the emphasis should always be on the future.  

Historical measures are only informative to the extent the business cycle is stable.  For example if  NWC for HVN is based upon 30 June averages, you may  pay significantly more if you settle 30 November with the XMAS build-up of inventory, even though your TEV already includes the value of XMAS earnings.  Therefore in setting the Target NWC it’s important to do the analysis using a couple of methods and to keep in mind the business operating cycle. 

Setting a reliable normalised Target NWC, along with maintenance of normal trading terms up until completion helps to ensure that the buyer gets the right level of NWC at completion.  However, the process of agreeing the Target NWC and the adjustments at completion can be almost as much as a negotiation as the TEV itself. This is where professional advice can really assist.   

Is all cash surplus?

The table above treats all cash as a surplus asset.  It’s well documented that Apple has $114 billion in cash on its balance sheet, much of it “trapped” overseas that nearly offsets all of its debt.

It makes more sense to look at cash levels relative to other metrics.  Cash as a % of revenue or as % of EBITDA for Apple is 31% and 104% respectively.  In other words, it has more than one years’ earnings sitting on the balance sheet as cash.  We don’t need to do a lot of analysis to know that level seems “surplus” to operating needs.  

The other companies show much lower cash holdings as a % of revenue or EBITDA (and much higher relative debt).  However even the ASX Small Ords. has 2/3rds of a years’ earnings as cash on average.  

Clearly there is a case that much of the cash balances shown for the above companies are surplus or net against debt.  

In theory, if the buyer purchases at TEV with all the NWC in place, on day one of completion in the morning he has receipts in the bank account from debtors and in the afternoon pays expenses.  However, as any business owner knows, you either need a cash buffer or an overdraft to manage the ebbs and flows of cash across a month.  So the buyer should either be prepared to contribute this cash float post sale, or negotiate a minimum level of cash to be retained in the business at completion.  The question is, how much, and who pays (buyer or seller)?  

How much minimum cash?

How much operating Target Cash that should be left in a business at sale must be determined much like the Target NWC through historical and forecast analysis of cash balances and relative to sales or operating expenses.  There is no “rule of thumb” answer as we can observe that actual cash balances retained by companies in practice is diverse: