Mini/Small caps SPA execution: Purchase Price Mechanism (Working Capital)
Hi,
with regard to really small companies (3 - 10m sales): How do you set the purchase price mechanism especially the working capital mechanism in the SPA?
In large deals, besides a debt/cash clause, I try to include a working capital mechanism (Target WC - Actual/Closing WC) as a correction mechanism at closing of the deal. Even there its hard to determine Target WC but at least you have an intra-year reporting to base on. With small companies though, which only have a rudimentary internal reporting (i.e. without reporting any work in progress or other inventory reporting during the year), it is hard to determine a Target value.
What do you do or what would you recommend? Do you even implement a WC mechanism or do you skip it? It is really a pain in the ass for me as 1. Sellers do not understand the mechanism and 2. due to the lack of information it is hard to negotiate on the Target value.
P.S.: I work outside the US in the engineering services sector.
Mick
Not sure what is considered standard outside of US. But it's common to hire accountants to do a quality of earnings even on small deals that would include a NWC PEG, and some kind of true up adjustment in the SPA at deal closing (and even a separate final NWC true up after closing). The QoE would try to "normalize" the NWC PEG. And assuming you're using average of LTM (or similar time frame), most of the months you'd capture in your average would include months that don't have typical year end gross ups (like WIP) that would otherwise accurately reflect NWC. As long as you're being consistent in how you're calculating the Target vs. Final, you should be directionally there. In any case, I tend to view NWC PEGs as a way of keeping the sellers honest moreso than trying to extract any economic value.
As far as explaining it to unsophisticated sellers, well...welcome to doing tiny deals. I have found that if you explain a NWC PEG in the context of how it could benefit them (i.e., the Final is greater than Target and so it's an increase to how much cash they'll receive), they suddenly understand it better...
I don't work at all in engineering services at all so I have no idea how WIP in that industry is actually recorded accounting wise. But couldn't you estimate what WIP is at any given time using some kind of Days or % of Sales / COGs method based on year-end actuals?
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