Mark Pestronk
Q: I am in the process of negotiating the sale of my agency. The potential buyer has sent me a letter of intent with an acceptable purchase price, but the letter has a clause that I find strange. The clause requires that I leave in the company a "level of working capital agreed to by both parties." I thought that in acquisitions, the seller gets to keep all of its cash and receivables. Is this an unusual term? Does it apply only to stock sales, or does it apply to asset sales, as well? How much working capital would a buyer want? Doesn't this requirement really do nothing more than lower the purchase price?
A: In my experience, the working-capital clause is a fairly new requirement in travel agency sales.
Before this year, I had seen it in very few acquisition agreements. Now a working-capital clause is becoming more common, and I would say that it has become universal where the buyer is backed by outside investors such as a private-equity group. It is probably driven by the investors' wish to avoid having to put any money into the agency other than the purchase price.
The term "working capital" means current assets minus current liabilities on the company balance sheet. In most cases, it means cash and receivables minus payables.
So when a letter of intent requires "a level of working capital agreed to by both parties," it means the agreed amount by which your cash and receivables must exceed your payables at closing. In most cases, it really means that you need to leave some cash in the company to cover the first few weeks' or months' expenses.
The rationale for the working-capital clause is that, even if the seller pays all his debts existing as of the closing, there will be new payables arising right after closing, and they need to be paid before new revenue comes in. So the buyer needs to have money in the company to cover the new payables.
In manufacturing and retail businesses, this rationale makes sense. You need to buy inventory and pay the staff before you bill the customers and get the proceeds of any sales.
However, in the travel agency business, the rationale is much more questionable. In corporate travel, transaction fee income arrives before most expenses accrue, unless you extend credit to clients.
On the leisure side, the agency can use client payments to cover current operating expenses until suppliers must be paid. So I see no real need for sellers to leave much money in the company, unless you have a lot of group and incentive business that requires months of planning before you get any money from the client.
Although the majority of working-capital clauses are found in stock purchases, I have seen them in asset-purchase agreements, as well. In the latter case, the buyer deducts the required working capital from the payment to the buyer at closing.
As you have suspected, the working-capital clause is really just a way of reducing the purchase price, and it should therefore be part of the negotiation. When the buyer proposes that the seller leave a large amount of working capital in the business, the seller can show that much less, if anything, is really needed.