Cash in the company’s price. Why a seller who fights over the operating minimum loses on the surplus

Three weeks before signing the sale agreement, the owner was still arguing with the buyer over a few hundred thousand zlotys of cash. The issue was the minimum that has to stay in the company after the deal. At the same time, the company’s balance sheet held an asset unrelated to the business that was worth many times more. No transaction document mentioned it. Without a separate carve-out in the agreement, such an asset passes to the buyer together with the company, with no addition to the price the parties have already agreed.

I have changed the details so that neither the company nor the parties can be identified.

The dispute over those few hundred thousand zlotys comes from a simple picture. On Friday the buyer gets the keys. On Monday the business has to buy raw materials and pay suppliers before receivables come in. If the cash left on Friday together with the seller, the company’s account is almost empty. For the business to run at all, the buyer has to put back into it as much as was just taken out. The same amount is then counted twice: once paid out to the seller, and once restored by the buyer. Usually the cash stays in the company’s account, and the seller wants the buyer to add it to the price for the shares. For the buyer the result is the same, because he would pay twice for the same money.

Most sellers treat the cash minimum as an attempt to lower the price. In fact it is arithmetic that the parties understand differently at the start. The seller loses money elsewhere: on the surplus he did not calculate and on the assets he did not exclude from the deal. In a seasonal company, the choice of the month used to measure the business’s needs alone changes this calculation by millions. With a balance of PLN 8 million after the season, the seller’s surplus may be PLN 6 million or PLN 1 million.

The rule and one exception

In a “cash-free, debt-free” deal, the buyer pays for the business itself. The price for the shares is the enterprise value plus cash and minus debt. The condition is a normal level of working capital on the transaction date, that is, inventory and receivables minus trade payables. The seller usually understands this rule more simply: the price is the value of the business, and all the cash in the account is added to it separately.

In transaction practice there is one exception to this rule, and it concerns cash itself. The minimum cash without which the business cannot stay liquid remains in the company and is already in the price, just like normal working capital. The buyer will not pay for it a second time, because he has already accounted for it in the multiple. The seller, on the other hand, is entitled to the entire surplus above this level. The surplus can be much larger than the minimum.

Enterprise value is usually calculated as a multiple of EBITDA, that is, operating profit plus depreciation and amortization. Such a valuation assumes a business ready to operate from the first day after the deal. To generate that result, the company maintained working capital all year and kept cash in its account for current expenses. The multiple therefore covers the business together with that cash. In the jargon of Anglo-Saxon advisers, this is the fuel that has to stay in the tank so the car you have bought can get from the showroom to your home.

If the same minimum first went to the seller and then had to be restored by the buyer, the same value would enter the settlement twice. That is why only the cash above the level needed for current operations increases the price.

The Monday test

At Capital One Advisers, at the start of a deal, we ask one question about every item on the balance sheet. Will the business run normally on the Monday after closing without it?

If the answer is “no,” the item stays in the price. This applies to the cash minimum and to normal working capital.

If the answer is “yes,” the item forms part of the surplus owed to the seller. This includes cash above the minimum and working capital above the agreed level. A separate category, and the one owners most often forget, is non-operating assets. These may be money from the sale of a property the company no longer needs, or any other asset that does not serve current operations. They sit outside the enterprise value and belong entirely to the seller. Taking them out of the company takes time and has tax consequences. It has to be planned many months before the process starts. A few weeks before signing, it is hard to carve out assets without a tax cost and without delaying the deal.

Some cash only looks free. The buyer will demand that cash blocked to secure bank guarantees and security deposits be excluded from the surplus. A similar dispute concerns the money in the company’s VAT account (rachunek VAT). The company can spend it only on purposes set out in the regulations, and for anything else it needs the consent of the head of the tax office. Advance payments from customers for orders the company has not yet fulfilled are usually treated by the buyer as debt, or included in working capital. The cost of fulfilling these orders will be borne by the company after the deal, while the money from the advances, counted as free cash, would go to the seller.

How much operating cash is in the price

The operating minimum is the amount that lets the business pay its bills even when the account balance falls to its lowest level in the month. That moment usually comes right after the transfers for salaries and taxes, and before the money from invoices issued to customers comes in. The average account balance does not show it. Buyers often propose the equivalent of a few weeks of operating costs here, sometimes a full month. The amount should, however, come from the data: how much cash the business uses between the day of its largest payments and the receipts from customers. The longer the business waits for those receipts, the higher the minimum.

Seasonality, or which month is the yardstick

In a business with seasonal sales, the calendar complicates the calculation. Cash and inventory move in opposite phases. Before the season, cash turns into inventory, because the business buys raw materials and produces for stock several months before the first sale. The account balance then falls to its lowest level, and the warehouse is full. After the peak of the season the situation reverses: the goods have been sold and there is cash in the account. The same account therefore looks full of surplus just after the season and empty in the middle of pre-season production.

The most common mistake made by the owner of a seasonal business comes precisely from the calendar. An example in round numbers: after the season there is PLN 8 million in the account. The owner assumes that the minimum is at most PLN 2 million, the cost of a quiet month, and treats PLN 6 million as his surplus. Pre-season production, however, drains the account almost to zero, because at the peak raw materials and production for stock absorb PLN 7 million. Measured against that peak, the surplus is PLN 1 million. The same PLN 8 million balance, set against a quiet month or against the production peak, makes a PLN 5 million difference in what the owner can claim.

That PLN 7 million is money that in a few weeks will turn into raw materials and finished goods. Economically, it is working capital that happens to be sitting in the account on the closing date. If the owner takes it out before the deal, the buyer will have to put it back in to start production. He will then recover it in the settlement, and how he does so depends on the agreement. If the parties agree on a fixed price based on a balance sheet drawn up after the season, the buyer will demand that this money be left in the account or will lower his offer. If, on the other hand, the price is adjusted according to the balance sheet on the closing date, the buyer will deduct this amount as a working capital shortfall, because after the season the warehouse is almost empty.

The opposite mistake is made by buyers. If a buyer calculates the cash minimum according to the peak of production spending and at the same time deducts a working capital shortfall measured against the annual average, he counts the same need twice. The company is then left with cash that was due to the seller. That is why the cash minimum and normal working capital are set together, on the same monthly data for a full year.

Where the seller really loses

Owners lose on cash in a different place from where they expect. The minimum is in the price anyway. The money slips away in two other matters.

The first is a dispute over the wrong thing. A seller who learns about the operating minimum only during negotiations usually takes it as an attempt to push the price down and challenges the principle itself. He loses weeks over it, and he still has to come back to the discussion of the amount. He also loses credibility with the buyer, who sees that the other side does not know the standard that applies in its own deal.

The second matter costs more, although it is less visible. A seller focused on the minimum does not watch over what really belongs to him. He may overlook the entire surplus: cash above the minimum and non-operating assets that he neither excluded from the price mechanism nor took out of the company before closing. The owner from the start of this article was arguing over a few hundred thousand zlotys, while assets worth many times more did not appear in any transaction document.

This calculation is made before the first confidentiality agreement

The cash minimum and normal working capital are set at the preparation stage. The EBITDA bridge I wrote about in May is built at the same time, and that is also when it is decided how much of the valuation will survive the buyer’s due diligence. A seller who calculates both figures before opening the process, and carves out non-operating assets in advance, comes to the negotiations with the data ready. The discussion is then about the price.

At Capital One Advisers we prepare this calculation before the first investor signs a confidentiality agreement. An owner who is thinking about a sale within the next 12 to 18 months should have it ready before the first description of the company for buyers.

Where arithmetic ends

Arithmetic does not settle everything. The size of the minimum is a matter of judgment, and each side has its own interest here. Month-end balances do not show the lowest balance during the month, and the last year may be atypical. A buyer who plans rapid growth will want more cash in the company than it has needed so far. That is already a matter of price.

The hardest case is a company with strong seasonality, where a yardstick has to be chosen for the combined needs for working capital and cash. The peak of the cycle protects the buyer from having to put in money in the first season after the deal. The annual average protects the seller from leaving cash in the company that the business needs for only a few weeks. Good processes differ at this point, and the advantage usually goes to the side that is first to present a consistent calculation based on a full twelve months.

Service: M&A advisory on a company sale