When selling a business, the cash available on the day of the transaction is often included in the calculation of the sale price. The higher the cash position, the higher the selling price, and vice versa. Between the negotiation of the sales price mechanism and the finalization of the transaction, several months can pass, during which cash flow fluctuates. To provide a framework for cash management during this period, and to take seasonal variations into account, a normative level of working capital requirement (WCR) is generally set, which has a direct impact on the final sale price.
AKCEAN can help you analyze your company’s financial cycles to determine the appropriate level of WCR, and negotiate it effectively to secure the sale price.
1. What is Working Capital Requirement (WCR) and why is it important?
Working Capital Requirement (WCR) represents the cash needed to finance a company’s day-to-day operations. It bridges the gap between cash inflows (customer payments) and cash outflows (supplier payments, social security charges, inventories, etc.).
Formula for calculating WCR
WCR is calculated from balance sheet data, by calculating the difference between current assets and current liabilities. Based on the main balance sheet items, the formula is as follows:
WCR = Inventories Trade receivables Tax receivables – Trade payables – Tax and social security liabilities
Example
For a company with the following balance sheet items:
- Inventories: €800,000
- Accounts receivable: €900,000
- Tax receivables: €50,000
- Trade payables: €400,000
- Tax and social security liabilities: €150,000
BFR = 800,000 900,000 50,000 – 400,000 – 150,000 = €1,200,000
In this example, the company needs €1,200,000 to finance its operating cycle.
2. Why negotiate a normative WCR in a transaction?
The selling price of a company is often determined by its Enterprise Value (EV), calculated on the basis of a profitability multiple. The final share price is obtained by adding net cash and deducting bank debts to the EV. Any change in cash therefore has a direct impact on the sale price.
To compensate for variations in cash flow from operating activities, it is essential to define a normative WCR. This represents a level deemed normal for the company’s working capital requirements, including open invoices (receivables, payables), inventories and tax and social security liabilities.
Price adjustment based on normative WCR
Normative WCR plays a central role in adjusting the final price of a transaction:
- If the WCR on the day of the transaction is lower than the normative WCR, the selling price is adjusted downwards.
- Conversely, if the WCR on the day of the transaction is higher than the normative WCR, the selling price is adjusted upwards.
Reasons for defining a normative WCR
When the pricing mechanism takes into account cash flow on the day of the transaction, defining a normative WCR becomes essential for the following reasons:
- Define a fair price: Normative WCR neutralizes one-off variations in cash flow due to the operating cycle, such as customer receipts, supplier payments, tax settlements or inventory fluctuations. It ensures that these movements do not skew the sale price.
- Prevent manipulation: In the absence of a normative WCR, the seller could artificially improve cash flow prior to disposal by accelerating customer receipts, delaying payment to suppliers or reducing inventory to free up cash.
- Ensuring continuity of operations: Normative WCR enables the acquirer to ensure that the company has sufficient working capital to meet its operational needs immediately after the transaction. If this level is not met, a downward adjustment to the sale price can be made to compensate for the imbalance.
Opposing interests of buyer and seller
Negotiating normative WCR is often a major point of tension between seller and buyer, due to their divergent interests:
- The seller seeks to negotiate a low normative WCR. This increases the likelihood that the actual WCR will be higher at the time of the transaction, resulting in a favorable adjustment for him and, consequently, an increase in the final sale price.
- The buyer, on the other hand, prefers to set a high normative WCR, reducing the risk of having to pay an upward adjustment and ensuring a financial safety margin.
These divergences underline the importance of a thorough and early discussion of normative WCR, ideally from the earliest stages of the transaction. The Letter of Intent (LOI), which formalizes the broad outlines of the agreement between the parties, is a strategic moment for setting this parameter and avoiding disagreements at later stages.
3. How is normative WCR defined?
Normative WCR is a key element in negotiating a balanced transaction, as it reflects the company’s real financial requirements.
Common calculation methods
- As a percentage of sales:
This method expresses normative WCR as a proportion of sales. Simple to implement, it enables direct comparison with industry standards.
- In days’ sales:
This approach estimates WCR in terms of duration, taking direct account of average payment and collection times to finance the operating cycle.
Integration of financial cycles
- Calculation based on a rolling period:
WCR is generally analyzed on a monthly basis, in relation to sales over the last 12 rolling months. Analysis over a past period (often 1 year) enables us to calculate a normative WCR by taking the average of observed monthly WCRs, often expressed as a percentage of sales. This method smoothes out seasonal variations to provide a representative estimate.
- Cash margin :
In the event of marked seasonality, an additional margin can be added to the normative WCR to take account of specific cash requirements during peak or off-peak periods.
Why is a rigorous methodology essential?
- Analysis of historical data:
Relying on reliable historical data, while integrating the specific features of the company’s business, enables us to set a level of normative WCR that is fair to both parties.
- Transparency in the final adjustment:
At the time of the transaction, a provisional share transfer price is generally established. Subsequently, an adjustment is made based on the difference between the normative WCR and the effective WCR recorded in the financial statements at the date of sale. This adjustment, which is made after the accounts have been finalized (generally a few months after the transaction), must be clearly understood and anticipated by the parties to avoid any disagreement.
4. Example of the application of WCR in an M&A transaction
The impact of WCR on the sale price can be significant. Here’s a practical illustration to help you understand how it is incorporated into the final price calculation.
Let’s assume that the buyer and seller agree on a valuation of the company based on an Enterprise Value/EBITDA multiple of 5x, with a normative WCR set at 10% of annual sales. The company generates an EBITDA of €4 million, which sets its valuation at €20 million (Enterprise Value or “EV”).
The latest available financial data show
- Bank debt: €3.0 million
- Cash and cash equivalents: €2.0 million
- WCR: €1.2 million
- Sales: €10 million (12 months rolling)
As the WCR of €1.2 million is higher than the normative WCR of €1.0 million (10% of sales), the difference of €0.2 million is in favor of the seller.
The provisional price of the shares, stipulated in the sale agreement and paid by the purchaser at the time of the transaction, is calculated as follows:
Provisional share price = EV – Bank debts Cash position WCR adjustment = 20 – 3 2 0.2 = €19.2 million
A few months later, the financial statements drawn up on the transaction date were finalized, revealing the following situation:
- Bank debt: €3.1 million
- Cash and cash equivalents: €2.1 million
- WCR: €0.8 million
- Sales: €11 million (12 months rolling)
This time, as the final WCR of €0.8 million is lower than the normative WCR of €1.1 million (10% of sales), the difference of €0.3 million is in the purchaser’s favor.
The final share price is therefore determined as follows:
Final share price = EV – Bank debt Cash position WCR adjustment = 20 – 3.1 2.1 – 0.3 = €18.7 million
The seller must therefore reimburse the buyer €0.5 million (19.2 – 18.7).
This example illustrates the significant impact that WCR adjustment can have on the final transaction price, particularly when it is not properly controlled.
5. Working capital adjustment vs. lock-in box: which mechanism to choose?
Another pricing mechanism, known as the “Locked Box”, consists in setting the sales price upstream, without adjusting the company’s cash flow. The choice between the WCR adjustment and the Locked Box depends on the company’s financial situation, the parties’ risk tolerance, and the complexity of the adjustments required.
Working capital adjustment: a price based on actual cash flow
The working capital adjustment is based on the actual cash position at the transaction date. This mechanism aims to accurately reflect the company’s financial situation and define a fair valuation for both parties.
The sale price is adjusted according to the cash available at the time of the transaction, taking into account open invoices (trade receivables and payables), inventories and tax and social security liabilities.
- Principle :
The sale price is adjusted according to the cash available at the time of the transaction, taking into account open invoices (receivables and payables), inventories and tax and social security liabilities.
- Advantages:
- Accuracy: this mechanism reflects the real value of the company at the transaction date, integrating its operating cycles.
- Fairness: ensures that variations in cash or WCR do not disadvantage either party, buyer or seller.
- Limitations :
- Risk of disputes: disagreements may arise after the transaction concerning the interpretation of the closing accounts, established at the transaction date.
- Complexity and costs: this mechanism requires detailed analyses, a clear methodology for setting a normative WCR, and an audit of the closing accounts.
To reach an agreement between seller and buyer, it is important to define a realistic normative WCR from the outset of negotiations. A precise analysis of seasonal cycles and cash flows helps to anticipate disagreements during discussions and avoid surprises after the transaction.
The Locked Box: a fixed price based on historical data
The Locked Box method involves setting the sale price in advance, based on the latest available financial statements (usually the annual accounts). From the date of these financial statements (the “Locked Box Date”), the economic risks and benefits of the business are transferred to the buyer, even if the legal transfer of ownership takes place at a later date.
- Principle :
Unlike the WCR adjustment mechanism, the price remains fixed, regardless of changes in cash or WCR between the Locked Box Date and the transaction date.
- Advantages:
- Clarity: the price is determined in advance, offering visibility to both parties.
- Simplicity: avoids complex adjustments and disputes linked to the establishment of accounts on the transaction date.
- Limitations:
- Limited adaptation: the price does not reflect the actual situation on the transaction date:
- For the buyer: he bears the risk of a deterioration in the financial situation between the Locked Box Date and the transaction date. However, he may require a minimum cash guarantee at this date.
- For the seller: he does not benefit from any improvement in the company’s performance, unless an earn-out mechanism is provided.
- Leakage risk: the seller must respect the buyer’s expectations regarding the management of the business between the Locked Box Date and the transaction date. Any cash extraction or expenditure not provided for in the contract (dividends, inter-company transactions, exceptional salaries, etc.) may be qualified as “Leakage” and give rise to post-transaction claims.
- Limited adaptation: the price does not reflect the actual situation on the transaction date:
How to choose?
Summary of the two methods :
| WCR adjustment | Locked Box | |
| Interest | Accurate price, reflecting the actual financial situation on the transaction date. | Fixed price, offering immediate visibility at the time of negotiation. |
| Complexity | Requires reliable and regular financial data to analyze WCR and negotiate a normative WCR, as well as detailed closing accounts. | Simpler: no post-transaction adjustments required. |
| Risks | Unknown final price until finalization of accounts at transaction date. Potential for disputes linked to the interpretation of these accounts and adjustments. | Management risks between the Locked Box Date and the transaction date: – For the buyer: risk of deteriorating financial situation – For the seller: risk of not being remunerated if the financial situation improves. – Potential disputes: possible disputes over leaks (unauthorized cash extractions) during the interim period. |
BFR adjustment: this method is recommended when the parties are looking for precision on the final price. It is particularly suited to complex or unpredictable financial environments. However, it requires considerable rigor and can lead to lengthy discussions, both during negotiations and after the transaction, when the final price is established.
Locked Box: this method is preferred for straightforward transactions, where the parties prefer clarity, simplicity and the absence of post-transaction adjustments. However, it requires a high level of mutual trust to manage the interim period (between the Locked Box Date and the transaction date).
Analysis of Working Capital Requirements (WCR) is a central element of M&A transactions, as it has a direct impact on the calculation of the sale price. By negotiating a normative WCR, a fair transaction can be achieved, taking into account the company’s actual financial cycles.
However, the Locked Box is a simplified alternative, offering greater visibility on the final price. The choice of method depends on the specifics of each transaction and the expectations of the parties involved.
AKCEAN, experts in mergers and acquisitions, can help you define the normative WCR, select the appropriate method (WCR adjustment or Locked Box), and optimize your financial negotiations. Contact us today to secure your sale price and maximize the value of your company.
