We lost 8% of equity value on day one because the peg was wrong.

Working capital adjustments are often underestimated in mid-market deals, often quietly shifting purchase consideration, and resulting in value leakage.

Why Working Capital Matters in M&A  

Working capital represents the funds required to continue operating the business as a going concern. It typically comprises items such as trade receivables, inventories, and trade payables. In M&A transactions, adjustments are made at completion to ensure a normal level of working capital is delivered. As a result, a poorly defined working capital peg may result in a purchase consideration creep.

The Trap: Seasonality and Working Capital Peg

Working capital pegs are typically calculated using historical averages. However, seasonality can affect the appropriateness of these pegs and may result in unusual spikes in working capital. For example, a business that experiences high sales during the holiday season may have higher working capital requirements during that period. A buyer could overpay for a business if the working capital peg was set based on a trailing 12-month average, that ignores seasonal inventory spikes. Similarly, growing businesses pose a risk if the peg is incorrectly set, as rapid growth can lead to increased working capital needs that are not accurately reflected in historical averages.

Common Mistakes

Common mistakes buyers make include blind reliance on a 12-month trailing average. Setting the working capital peg is not a mathematical exercise, it is a delicate balance to consider what is required to operate the business as a going concern, taking into consideration factors such as growth trajectories and carve-out adjustments. Buyers often fail to account for these factors, leading to inaccurate working capital pegs and potential financial losses.

Getting it right

• Consider seasonality in monthly working capital trend analysis: Analysing monthly trends can help identify seasonal patterns and adjust the working capital peg accordingly.
   
• Normalise for growth and carve-outs: Adjusting for growth and carve-out impacts ensures that the working capital peg reflects the current state of the business.
   
• Sensitise working capital to assess the impact of changes to components of working capital: Understanding how changes in components such as trade receivables, inventories, and trade payables affect working capital can help in setting a more accurate peg.
   
• Appropriately define normalised working capital in transaction documents, including specific policies surrounding working capital items: Clearly defining what constitutes normalised working capital and including specific policies in transaction documents can prevent misunderstandings and disputes.
   
• Negotiate transitionary arrangements to consider working capital arrangements: Transitionary arrangements can help manage working capital during the transition period, ensuring that the business continues to operate smoothly.

Appropriately determining your working capital peg protects a buyer from unwanted purchase consideration creep and value leakage. It isn’t just a number, it’s real money. Avoid a scenario where the statement at the top applies to you, whatever that number may be. By carefully considering factors such as seasonality, growth, and carve-outs, and by clearly defining working capital policies in transaction documents, buyers can protect themselves from financial losses and ensure a successful transaction.