It may not officially be the solicitor's job to take into account working capital when acting for a client selling their business, but for the smart practitioner who wants to keep their client happy it is worth considering from the outset, says Joanna Smith.
You may have been fortunate enough to have spent time advising a client selling a business. That client may have spent years building their company. A large proportion of their personal wealth will probably be tied up in its sale. It is likely they will be finding the whole process stressful and very quickly you will have learned that there are plenty of ways your client can become a little grumpy. And it’s probably the grumpy clients who most resent paying their legal fees. You don’t want a grumpy client.
A quick master class: winding up a business owner
One of the quickest ways that a business owner can become upset is if he suffers a last-minute price ‘chip’. That is, a price reduction late on in the process.
So, what is working capital and what is its role in a last-minute price chip? What’s the possible impact on a deal? No one working on a transaction is thinking that working capital is the solicitor’s responsibility. But is there anything the streetwise lawyer could look out for? When might working capital become an issue? What kind of things could be done during the process to avoid the last-minute price chip?
Even if it’s outside your responsibilities, a few well-chosen words in your client’s ear and you could suddenly find you have become endearing. This of course is no bad thing, given you are hoping your client will only be too happy to write out a cheque for your services later on in the process.
Working capital: a plain-English guide
Working capital is the funding needed to operate a business over the short term. If customers are paying more slowly, less cash is flowing into the business. More short-term funding is required to keep the business operating. Working capital requirements have increased.
Alternatively, if a business is able to delay paying its suppliers, short-term cash outflows and short-term funding requirements drop. A delay in supplier payments results in a reduction in working capital requirements.
Business change is going to drive working capital requirements. Working capital and short-term funding requirements are going to increase for the business whose suppliers suddenly demand to be paid more promptly, or the business that has to wait for more cash from customers. Any increase in the lag between suppliers being paid and customers paying is going to drive working capital and short-term funding requirements upwards.
So, a business that is growing quickly might have high working capital requirements. Doing more work for more customers means more cash is required to fund activities.
A company that is developing more business with a longer delay between doing work and getting paid will see its working capital requirements increasing. Think about a company diversifying into oil exploration or drug development. A business that is becoming more seasonal, manufacturing in one part of the year and selling in another, might also see working capital requirements increasing.
For some businesses, working capital requirements are going to be a bigger issue than others. Contrast the rapidly expanding Christmas tree producer (scaling up quickly, long production cycle, seasonal business) against the well-established greyhound race track operator. In one of these businesses we might expect working capital to be more of an issue than the other!
Solicitors and other advisers: what’s the impact on deals?
When purchasing a business we can almost predict that the buyer’s accountants will try to use financial data to argue that the target business has higher than anticipated working capital requirements.
What’s the impact? Put simply, identifying higher than expected working capital requirements gives the buyer all the ammunition they need to try and reduce their asking price.
The buyer may argue that the seller has mis-represented the working capital requirements for the business. The buyer might argue that it is raising all the debt it possibly can as part of the purchase. The buyer has to keep some debt facilities in reserve to fund the unexpectedly high forecast working capital requirements.
With the new information, it appears that not all of the debt raised can be paid out to the seller. The seller is presented with a last minute price reduction: a last minute price ‘chip’. If the seller has been dealing exclusively with one buyer, and other potential buyers have left the process, the seller may feel they have little option but to accept.
Preparing for the debate
Think about the rapidly expanding Christmas tree producer. The owner of that business knows a lot about selling Christmas trees and even a little about managing working capital. Unfortunately, having never sold a business before, they may be blissfully ignorant regarding last-minute price chips. Fortunately, that same client has had the presence of mind to retain a commercially-focused streetwise solicitor who has invested carefully in their own CPD (and studied this course material carefully).
What could the seller of the rapidly expanding Christmas tree producer do to prepare for a debate about working capital requirements?
The ‘do nothing’ strategy
‘Do nothing’ is always a possibility, and it’s not completely without logic. The argument here is that the buyer might not raise working capital as an issue at any point in the process. The seller bargains on buyer ignorance or stupidity or the seller’s own absolute confidence that any detailed investigation will show that the business is being sold with a robust working capital position.
However, ‘do nothing’ could be a very risky strategy. The buyer’s accountants expect to be rewarded handsomely for the work they are doing to investigate the finances of the target acquisition. They know added value equals a happy client. You can probably almost bet that one of the ways they are going to generate value is by doing everything they can to find data that points to working capital requirements that are higher than expected. They are highly motivated to provider the seller with all the ammunition they need to justify the last-minute price chip.
Do nothing means the owner of the rapidly expanding Christmas tree seller could find themselves suffering a price reduction late on in the process. For you the last-minute price reduction could mean a grumpy client who is not 100 per cent happy about writing out that cheque for your services.
We should be able to do better than ‘do nothing’.
What's the alternative strategy?
The alternative for the seller is to work to prepare themselves in advance of a potential argument. The seller could present a picture of ‘normalised working capital’ for the business and argue that any extraordinary fluctuations, e.g. two years ago, were one-off. This strategy sees the seller trying to get on the front foot and looking for an opportunity to present their own view of working capital.
Opportunities for the seller to present their own picture of working capital include:
1. The information memorandum (early in the process). This is a bit like a business plan, released early on to all bidders in the process. It is designed to contain all the information a potential buyer should need to bid for the business. The information could contain a broad overview of working capital requirements, but in practice release of detailed working capital requirements this early on is very rare.
2. Vendor due diligence. Here, the seller commissions their own accountants to provide a detailed picture of the business’ finances and releases this to short listed bidders. But accountants, like lawyers, are by nature thorough. Talk to any about conducting vendor due diligence and you will be amazed at what they feel they need to look at. And they don’t come cheap. And all of this work has to be done before the seller can even be sure they have a committed buyer for the business. And what the accountants may not tell you is that some buyers may discount the information contained in the vendor due diligence report anyway, given that it was prepared by the seller early on in the process.
3. A focused piece of work around working capital requirements. Alternatively, without commissioning a large piece of vendor due diligence, the seller could just ask his advisers or accountants to provide some supplementary information relating to the business’ working capital position, once the identity of short listed bidders is known.
4. Dataroom (late in the process). The seller could provide some information on working capital in the dataroom. This is relatively late on in the process when the buyer has his own accountants trawling through files of information on the business’ contracts and finances. Success here assumes that a number of buyers are proceeding through to this phase of the process (or at least waiting in the wings, eager to jump back into the process) and the seller is not already stuck with one bidder who is looking for any excuse to chip away at the price.
So, quite a few options. Alternatively, if there are some fly-by-night advisers reading this, and all of 1-4 sounds like too much trouble and work, there’s always the ‘do nothing’ option. The later it is left and the fewer buyers remaining in the process, the more likely it is that the seller could be forced to accept a price reduction from a buyer concerned about working capital. ‘Do nothing’ really does seem like a recipe for a last-minute price chip and a grumpy client!
What should the streetwise solicitor do?
Just a very few well chosen words could make all of the difference to how much your client appreciates your input.
Imagine you were the one person on the deal who was smart enough to check something with the client. Imagine early on you were sitting down with the client to map out the process and agree the scope of your work. Imagine the seller told you he had asked his accountants to amalgamate some information for the buyer’s accountants. Imagine you were smart enough to ask this question: “And what are you expecting the buyer’s accountants to discover about the working capital position for this rapidly expanding Christmas tree producer?” Think what an opportunity you could have to talk to them further and impress them.
Even if the conversation led nowhere, maybe working capital could, by some amazing fluke, become an issue in the sale of the rapidly expanding Christmas tree producer. Maybe your client vaguely remembers your thinly veiled warning about working capital. Maybe as the deal starts to drift south, suddenly you’re the one person your client is relying on (given that you perhaps were the only one to be smart enough to mention the issue early on). If your client is destined to become grumpy about the deal, surely it would be nice if they were least grumpy with you?
Hang on, isn’t working capital someone else’s job?
‘Yes’ and ‘no’. Worrying about working capital is far outside the formal job description for any solicitor. In an ideal world there would probably be a savvy accountant who had raised the same issue. But clients are sometimes slow to involve their accountants (after all, they’re almost as expensive as solicitors) and sometimes they’re brought in late working to a very tight budget, so are not that closely involved. In any case, accountants, like solicitors, are not all savvy.
So, it really depends how you see your job. Are you limiting yourself to the role of nit-picking drafter of documents (which, of course, does have value for your client)? Or are you the commercially focused streetwise solicitor, in touch with your client, speaking to them from the start, involved in the strategy for the process, making sure your position is absolutely cemented as ‘trusted adviser’ in your client’s eyes?
It’s your choice. You decide. At some point, if you find yourself advising the seller of a rapidly expanding Christmas tree producer, it could just help to check your client appreciates the potential impact of working capital.
Joanna Smith is a business development director at Financial Training Associates
Reprinted from Solicitors Journal
Posts
No comments:
Post a Comment