In acquisition agreements, working capital adjustments are a common tool used to ensure the target company has sufficient funds to support ongoing operations after the transaction closes. These adjustments, along with strategic decisions about real estate and long-term assets, are intended to create a fair balance—ensuring that buyers aren’t left with a cash shortfall and that sellers don’t forfeit excess funds unnecessarily.
Managing working capital adjustments and evaluating real estate and asset structures takes on added importance. Striking a balance between retaining enough working capital to sustain operations and finding ways to distribute any excess funds is key. Without thoughtful planning, companies risk leaving funds on the table or facing last-minute reductions to the sale price. This process often involves not only optimizing working capital levels but also reviewing potential distributions of excess funds in a way that aligns with regulatory and tax requirements.
Key Areas to Focus On:
1. Assess Working Capital Benchmarks and Normalization
Precise working capital targets are essential to avoid unexpected price adjustments at closing. Here’s how to accurately assess and set benchmarks:
- Establish Historical Working Capital Trends: Calculate the average working capital over the past 12–24 months, accounting for seasonality, to create a reliable benchmark that reflects typical operational needs. Adjust for one-time events to prevent skewed targets.
- Set Realistic Targets: Factor in future growth and operational changes that might impact working capital needs, and benchmark against industry standards to align with buyer expectations.
- Evaluate Seasonal Trends: Establish seasonally adjusted targets to reflect predictable cash flow fluctuations. Documenting these needs can help ensure buyers understand the rationale behind working capital benchmarks.
- Maintain Consistent Reporting Practices: Use consistent data sources for working capital calculations to avoid discrepancies with financial statements. Regularly update benchmarks to reflect changes in business conditions.
2. Clean Up the Balance Sheet Ahead of Time
Balance sheet clean-up should begin early, ideally well before the sale process. A clear and accurate balance sheet can eliminate potential issues and increase valuation. Consider these steps:
- Clear Out Non-Operating Assets and Liabilities: Identify non-core assets, like surplus equipment or investment holdings, and consider transferring them to a separate entity. Settle outstanding liabilities and credits to present a cleaner financial picture.
- Address Aged Receivables and Payables: Write off uncollectible receivables and reconcile old payables that are no longer owed. These steps improve the working capital position and prevent adjustments to the sale price.
- Eliminate Excess Inventory and Adjust Valuations: Liquidate or discount excess or obsolete inventory and adjust valuations to reflect current market conditions, giving buyers a realistic view of asset worth.
- Review Prepaid Expenses and Accrued Liabilities: Ensure prepaids and accruals are accurately stated, aligning with actual expenses. Accurate accruals prevent unexpected queries and adjustments.
- Document Adjustments Thoroughly: Keep detailed records of all adjustments, providing buyers with an audit trail that builds trust and minimizes delays in the sale process.
3. Consider the Treatment of Real Estate and Other Long-Term Assets
Strategically managing real estate and other long-term assets can add significant enterprise value while streamlining the transaction. Key strategies include:
- Evaluate Real Estate Ownership Structure: Consider transferring real estate into a separate LLC or holding company before the sale to simplify negotiations. This structure can allow the buyer to focus on operational assets while enabling separate negotiations for real estate or allowing the founder or existing shareholders to retain ownership through a long-term lease arrangement.
- Optimize Real Estate for Valuation: Prepare Real Estate for Sale: Address any deferred maintenance and consider minor updates or cosmetic improvements to enhance perceived value. Obtain an independent appraisal for high-value real estate to support negotiations, facilitate buyer due diligence, and set realistic expectations.
- Assess Other Long-Term Assets for Retention or Sale: Identify non-essential assets, such as machinery or vehicles, and consider selling or liquidating them pre-sale. For intangible assets like patents or trademarks, consider retaining these assets under a different entity and licensing them to the buyer for potential recurring revenue.
- Address Environmental or Zoning Compliance Early: If real estate has environmental or zoning considerations, address these early in the process to mitigate risks. Clear documentation on compliance and inspections reassures buyers and avoids potential post-closing liabilities.
Managing Excess Cash Ahead of a Sale: Key Considerations
If you’re one of the fortunate ones with excess cash in the business, it’s essential to handle these funds strategically. Managing excess cash effectively can allow owners to extract value, optimize tax outcomes, and ensure the business remains attractive to buyers. Here are some key considerations for distributing or reallocating excess cash in preparation for a sale.
1. Evaluate Dividend Distribution vs. Retained Earnings
- Declare a Dividend to Shareholders: If the business is generating more cash than needed for operational purposes, consider declaring a dividend to distribute excess funds to shareholders. Dividends allow owners to extract cash without altering the company’s equity structure.
- Consider Timing and Tax Implications: Ensure that the dividend aligns with the company’s financial cycle and consult with tax advisors to understand the implications for both the business and individual shareholders. Distributing dividends before a sale may minimize tax burdens for sellers.
- Keep Enough Cash to Support Working Capital Needs: While extracting excess cash, ensure there’s sufficient funding to support day-to-day operations. Establishing, monitoring, and understanding working capital benchmark levels and requirements, as discussed earlier in the article, will help determine the optimal cash and working capital levels needed to maintain smooth operations and meet buyer expectations.
2. Set Up a Share Buyback for Minority Owners (if applicable)
- Redeem Minority Shares Using Excess Cash: If the company has minority shareholders, consider using excess cash to buy back shares, consolidating ownership and potentially simplifying the transaction for a future buyer.
- Assess Ownership Implications and Impact on Valuation: Reducing minority shares can streamline ownership, but ensure the buyback doesn’t adversely impact the company’s overall valuation or any investor rights in the sale process.
3. Transfer Excess Cash to a Holding Company or Personal Investment
- Set Up a Holding Company Structure: Transfer excess cash to a holding company controlled by the primary shareholders. This approach moves cash outside the operating entity, reducing taxable income within the business and maintaining liquidity for shareholders.
- Consider Personal Investment Vehicles: For smaller businesses, owners might transfer excess cash to personal investment accounts or trusts, reducing taxable income for the business and protecting personal assets in tax-efficient ways.
4. Address Excess Cash in Negotiations
- Discuss Excluding Cash from the Sale: Buyers may be willing to negotiate terms that exclude excess cash from the final transaction, reducing the need for an immediate cash distribution. Clarify with buyers whether the sale price is “cash-free, debt-free” to avoid confusion.
- Negotiate a “Working Capital Peg”: Set a working capital target (peg) that reflects normal operating needs. Cash beyond this peg can be distributed to shareholders or removed from the sale, ensuring the seller retains control over surplus funds.
5. Tax Planning for Optimal Outcomes
- Consider Dividend Tax Rates and Capital Gains: Dividends and capital gains are taxed differently, so understand the implications of each option. Consulting a tax advisor can help determine the most advantageous distribution method.
- Use Timing to Your Advantage: If sale timing is flexible, plan dividends to minimize tax liabilities or take advantage of lower tax rates in the current year.
6. Communicate Cash Distribution Strategy Clearly to Buyers
- Maintain Transparency on Working Capital Needs: Show buyers how much cash is necessary for operational stability and clarify that any excess will be distributed to shareholders. This transparency builds buyer confidence and can simplify due diligence.
- Document Any Cash Movements Prior to Sale: Keep detailed records of any dividend distributions, buybacks, or transfers to holding companies. Buyers and advisors may require explanations of cash outflows to validate the business’s financial health.
Final Thoughts
Working capital adjustments can significantly influence the final valuation in any acquisition. Addressing working capital needs, timing balance sheet clean-up, and making strategic decisions about real estate and long-term assets all play a role in maximizing value. By assessing these areas early and thoroughly, you can position the company to achieve the most favorable terms at closing.
Additionally, improving cash flow management by monitoring key metrics and optimizing the cash conversion cycle can strengthen liquidity, ensuring that sufficient working capital is available without unnecessary strain on operations. Effective cash flow management can also result in additional cash available for distribution prior to the sale, enhancing returns for stakeholders. Stay tuned for our next article “Optimize Cash Conversion Cycles To Improve Working Capital Trends” for ideas on improving your cash conversion cycle to free up cash and enhance liquidity, providing a valuable boost to working capital as you prepare for a sale.
Before making any structural or financial decisions related to the sale, consult with a qualified tax advisor and legal professional to ensure optimal structuring and compliance. Early guidance on tax implications and legal requirements can help mitigate potential risks and maximize after-tax proceeds, supporting a smoother and more efficient transaction process.