Negotiating the Working Capital Settlement
Far and away the biggest “negotiation within the negotiation” is the settlement of working capital. I’ve done deals where each of the main two methods were utilized: 1) variance from a target which reflects the recent run-rate relationship between current assets as well as current liabilities and 2) straight netting of those current accounts (negative sum reduces purchase price, positive sum increases).
Each method has its complexities as well as its pitfalls, and in both cases the challenge arises from the necessity of creating a closing balance sheet that must be produced in the heat of the battle. The balance sheet is typically based on a partial period and is executed well before the period is actually ready to be closed. As a result, several accruals and estimates are necessary. Procedurally, the most important step for getting to a closed balance sheet is building an over-the-top ledger that enables quick execution of journal entries in Excel and robust analysis of the impact of those entries onto the last officially closed version of the balance sheet. Without a tool that can facilitate these quick iterations of the closing balance sheet, the process can be bogged down in system errors before the fun stuff can even begin.
The Target Method
The target method of settling working capital provides the most fodder for a deeply philosophical fireside discussion since it encompasses the meaning and nature of “run-rate.” Once you’ve come to a perspective on run-rate, the next step involves a very meticulous, deep dive through all the current accounts with the purpose of sorting out any one-time anomalies that should be excluded from the target. Since the buyer’s side is certain to have differing views on what should be considered as one-time anomalies, the key to success is providing historical data to back-up your perspective and help you articulate your position.
The Netting Method
The netting method is more of a street fight, which may sound surprising since it seems like the more straightforward method. With this method, GAAP accounting – particularly in the case of a private company being bought by a public company – can be a source of great debate and argument (which is a bit counter-intuitive, given that GAAP’s intent is to set clear rules for scorekeeping). Be prepared to debate on revenue recognition methods (become familiar with the term VSOE if you are a software company that sells both licenses and services), classification of an asset or liability as current or long-term, the nature of various operating agreements as well as leases to be contemplated as balance sheet or off-balance sheet items, and (my favorite) accruals for every imaginable negative contingency that could happen in the future but which “should be” foreseeable at closing.
For deals that first sign and then close, don’t preemptively celebrate the signing, because you are going to need your sharpest wits to cross the crocodile pit of negotiating the working capital settlement and reach the true moment of celebration.