As an acquisition closes, the investment banker representing the seller calculates the working capital “peg” (WCP), a figure resulting from current assets minus current liabilities, with some exclusions. (A good investment banker actually models the WCP continually for the seller long before the closing, but the WCP peg is set as the acquisition closes, using the very latest balance sheet numbers.)
Assuming the company is being sold on a cash-free/debt-free basis, let’s look at how the working capital peg is determined, because there are some idiosyncratic exclusions and inclusions when using the very common cash-free/debt-free deal format. On the current asset side of the ledger, the working capital peg will exclude “cash and cash equivalents,” all of which go to the seller. The current assets include inventory, accounts receivable, and most prepaids. For current liabilities, the WCP will include accounts payable, and most accruals. By subtracting these current liabilities from current assets, you determine the WCP. In nearly all transactions, there is also a “true-up” adjustment 90 days after the closing. Note that the value of the inventory is on the asset side of the WCP calculation. A pressing issue in acquisitions today is how far back in time to look when calculating the WCP. With the recent volatility of lumber prices, sellers want to calculate the WCP using a trailing-twelve-month (TTM) timeframe, in order to reflect a more normal inventory in the WCP; whereas buyers want to look back just trailing three months, “T3M,” to reflect a more normal current inventory.
For example, let’s say that you have a lumberyard that just sells 8′ 2x4s. And say you always carry 100 2x4s in inventory, replenishing them as they are sold. For ease of math, let’s say you paid $1 for each 2×4 a year ago. You had $100 worth of inventory on your balance sheet. If the price of 2x4s doubles over the ensuing 12 months to $2/stick, you carried the same number of 2x4s, but they had a higher value on your balance sheet: $200. You are likely selling at the $2/stick level, even though your blended average for acquiring that stick was—to your advantage as a seller—less than that.
If the WCP were calculated on a trailing-twelve-month basis, the longer view is to the advantage of the seller, because the seller acquired inventory for less than the value on the balance sheet. (When selling that inventory down, this price arbitrage is reflected in higher gross profit dollars, and higher EBITDA, even though the seller is selling the same number of sticks).
That said, if the WCP were calculated on a trailing-three-month basis (T3M), it is to the advantage of the buyer, because they are acquiring inventory that they will have to replace at the higher $2/stick price.
Sellers want the longer view; buyers want the shorter view.
At the 90-day true-up, if the trailing-twelve-month perspective were used, the seller is likely to get an additional check from the buyer, because the WCP would normally be lower than the true-up amount. Conversely, at the 90-day true-up, if the T3M perspective were used, there would probably be less variation between the closing WCP value and the true-up value.
With volatility of lumber prices still in effect, even the trailing-three-month model might not accurately reflect the true WCP. Ironically, with lumber prices falling from their highs, it may be that the trailing-twelve-month model comes back into favor, if it turns out to be more-accurate and fair to both the buyer and the seller. That said, for deals closing before prices come back to pre-pandemic levels, you will probably see buyers and sellers meeting in the middle, by calculating the WCP based on a trailing-six-month basis (T6M), rather than the over-long “12” or the very-short “3” look-back.
No matter what model is agreed upon, don’t treat the WCP as an afterthought. It should be calculated by a qualified CPA on a running basis going into the closing, so there are no surprises for either buyers or sellers as you get close to signing the purchase agreement. Finally, getting the WCP right has financial implications that reach far beyond just a few dollars either way. As a seller, the advocacy of your investment banker is invaluable in the WCP determination, not only for undertaking the difficult calculation, but for defense of the model used as well.
John Wagner is a managing director at 1stWest Mergers & Acquisitions, which offers a specialty practice in the LBM sector. Reach John at j.wagner@1stwestma.com
