Working Capital Series: Locked Box
One of the most contentious issues when buying/selling a business is the working capital adjustment at settlement. This is often a bone of contention because it goes to value, is easily manipulated and changes on a daily basis.
My suggestion in a recent post was to draw a line in the sand and agree a working capital figure so a dollar-for-dollar adjustment could be made at settlement. For example, we may agree that working capital will be $10m at settlement, with at least $4m in cash. So at settlement, if working capital is different, we can make a dollar-for-dollar adjustment to the purchase price. The problem with this method is deciding the level and dealing with all of the variables in the interim period.
A few comments from readers suggested I consider the locked box approach. I have seen this used previously, but my initial thought was the settlement date would need to closely follow the receipt of audited statements. Otherwise, you’d be getting the upside of a business that you don’t legally own (you’re not exposed to the full risks yet). However, there’s a solution, which I’ll mention after explaining how the locked box approach works.
In the broad strokes, the locked box approach uses the most recent financial accounts to lock working capital drivers and hand economic interest of the business to the vendor. In simpler terms, the vendor cannot take a cent from the business after the accounts are locked, and the investor bases his/her valuation on this scenario. Of course, working capital won’t be the same at settlement, but any movements will offset net debt in the EV calculation and the original valuation will hold true. If the vendor must take value from the business for some reason, a similar adjustment can be made.
As for the problem of receiving profits while not holding business risk, well, the locked box solution is to introduce an interest charge over the business whereby the vendor receives compensation for holding the risk. Most likely this interest charge will offset the purchase price. This isn’t a perfect solution by any means, because the interest charge introduces subjectivity into the locked box method. But, it does seem to be the lesser of two evils.
