Having just been through a deal where negotiations fell apart over working capital levels, I thought it worthwhile to share some of my observations on this matter.

When negotiating an M&A transaction, few sellers of software companies believe the balance sheet will be of importance in determining the valuation. This is true for the most part, as many valuation methodologies common to traditional businesses, such as book value, just don't apply to software companies which typically have few tangible assets. However, the buyer will want to determine what assets and liabilities they will be assuming at close.

Typically, whether an asset or a stock purchase, the buyer will assume control of all assets, including cash and other liquid assets, inventories, accounts receivables, and any prepaid accounts. Liabilities will typically include trade payables, accrued payroll taxes, and deferred revenue. Few buyers will assume any long term liabilities, and if they do, will generally reduce the purchase price by a corresponding amount.

The Letter of Intent (LOI) will typically spell out balance sheet requirements at close. The logic for this is to assure that the buyer will not be handed over a business where assets have been distributed or additional liabilities incurred between LOI and close.

Another requirement to close may be that a certain amount of working capital be delivered. Working capital is generally defined as current assets less current liabilities. This may or may not be a positive amount, as liabilities could exceed assets, especially if a substantial amount of deferred revenue is on the books due to maintenance and services that cannot be recognized in the current period. Positive or not, what is important is to get agreement between the buyer and seller as to what that number is so the seller can plan to deliver that at close, and the buyer knows what they can expect to receive.

Buyers generally are seeking a level of working capital that is adequate to fund the business needs after close, without the need for additional capital. Should there be inadequate capital, the buyer may need to make a capital infusion, and will likely want to reduce the purchase price to compensate for the additional investment requirement.

Ideally, the working capital delivered to the buyer will be in excess of that required, and the seller will receive an increase in the purchase price, if that was negotiated into the agreement. If the working capital is in excess of the cash needs of the business, then the seller will likely want to distribute cash before closing if there is no corresponding increase in the purchase price. Of course, if there is a shortfall, expect to see a reduction in the purchase price.