• 093 02/19/2020

    The working capital adjustment in a stock purchase agreement can have a direct impact on the price paid for the business. Given that price is arguably the most important variable in a transaction, and that the working capital adjustment can impact price, it follows that the working capital adjustment deserves special attention. (PDF Document) 

    This adjustment is required because it is impossible to know what a company’s working capital will be on a future date (specifically the date of the sale). It can take a business anywhere between a couple of weeks to a couple of months to close its books, making this an adjustment that can only take place after the transaction has closed.
     
    Sequence for the Working Capital Adjustment: 
    On the date of the transaction, the Buyer will pay to Sellers an initial purchase price, which is subject to an adjustment for working capital (note: additional adjustments can be included, but this post will focus solely on the working capital adjustment). The initial purchase price will include an estimate for working capital for the transaction date (Target Working Capital). 
     
    Between 60 and 120 days after the closing date, the Buyer will then deliver a statement to Sellers with their calculation of working capital (Final Working Capital). If all parties agree that the calculation is accurate then an adjustment will be made as follows.
    1. If the Final Working Capital is greater than the Target Working Capital (Excess Amount), then Buyer shall pay directly to Sellers an amount equal to the Excess Amount, and Buyer and Sellers shall promptly deliver a joint written instruction letter to the Escrow Agent to release all funds in the Working Capital Escrow Account to Sellers.
    2. If the Final Working Capital is less than the Target Working Capital (Shortfall Amount), then Buyer and Sellers shall deliver a joint written instruction letter to the Escrow Agent to release an amount equal to the Shortfall Amount from the Working Capital Escrow Account.
    Example to Provide Context:
    When a healthy business is acquired, the purchase price is generally based on a multiple of earnings (commonly EBITDA). What the purchase price assumes, among other things, is that the business will have adequate working capital on the date it is acquired to maintain this level of earnings.
     
    For a simple example, let's eliminate all working capital accounts with the exception of inventory. Assume that you acquire a business that uses raw materials (a component of inventory) to sell a finished good. Post acquisition you learn that the business does not have any inventory. This is an extreme example that would hopefully never occur because you followed a proper due diligence plan, but it helps communicate the need to adequately measure working capital accounts. Without raw materials production would halt and you would have to use cash to purchase the amount of inventory required to continue operating. The working capital adjustment in a stock purchase agreement secures this cash from the sellers so that the buyer is made whole. 
     
    In other words, the working capital adjustment makes sure that the buyer receives a historically normalized level of working capital at closing so that the business can be operated as it was prior to the transaction.
     
    Stock Purchase Agreement Language:
    The linked document contains hypothetical language detailing the above sequence as it might appear in a stock purchase agreement.  
 



  • 092 02/04/2020

    If an investment were to grow by precisely 6.7% each year for 200 years, and then lose half of its value in year 201, how would the investment record change?

    An article by Jim Grant, one of my favorite financial writers and analysts, highlighted this excellent thought exercise which provides an entertaining way to explore the difference between the two most commonly cited measures of investment performance: the internal rate of return (IRR) and the multiple on invested capital (MOIC). From the article:
     
    “Take that 200-year, 6.7% compound real return which [Jeremy Siegel, author of Stocks for the Long Run] first electrified the reading portion of Wall Street in 1994. …how would the record change if, in year 201 the market fell by 50%?”
     
    To provide some context, if a $100 investment achieved a 6.7% compound real return for 201 years the value of that investment at the conclusion of 201 years would be approximately $46 million. So what would the 201-year compound real return be if the value dropped to approximately $21 million in year 201 instead?
     

    IRR Portfolio Comparison

     
    The article continues:
     
    “You suspect that a 50% drawdown would play ducks and drakes with even a two-century performance record, and you confidently say so. But you are wrong: In fact, that seeming disaster would reduce it merely to 6.3%, a scant 40 basis points.”
     
    It is a surprisingly small discrepancy, and I wanted to use this as an opportunity to demonstrate the massive discrepancy in MOIC between the same two scenarios. The spreadsheet visible below can be downloaded here.
     

    IRR vs MOIC

     
    Comparing these two scenarios against one another, you will notice that the MOIC is less than half in the second scenario, but the IRR for the cash flows suggests little has changed. It goes to show that an investment’s time horizon is the reason that both of these metrics should always be considered when evaluating performance. 
     
    To take the point a step further, imagine if in year 201 the investment lost 99% of its value. How drastic would you expect the difference to be in the event that an investment’s value is all but wiped out? A 99% loss in year 201 after growing at 6.7% for the prior 200 years would result in an internal rate of return of 4.25% for the entire investment period. In stark contrast, the value of the investment would be $429,422 versus $45,819,285 had it just continued to grow at 6.7% in year 201 (download the template if you would like to make this change yourself).
     

    IRR vs MOIC Portfolio Wipe Out

     
    Jim Grant wrote the article to demonstrate that “stocks, as measured over generations, appear invincible.” But I thought it also provided an excellent opportunity to demonstrate why IRR and MOIC should be used in tandem to measure investment performance. While it is clearly an extreme example, I find that extremes can occasionally help communicate valuable lessons.  
     
     
 



  • 091 01/23/2020
    The LBO case study and financial modeling test are now live as part of the LBO Video Series. Please see the link that follows for the updated files: LBO Case Study: BabyBurgers LLC. The introductory video is also available below. 

    I wrote this case study after over a decade in private equity with the objective of designing a LBO test that would help me identify talented junior team members. I have also personally used this test in a live hiring process. The case study was sent to a group of second-round interview candidates to help us evaluate each candidate's skill set before making an offer to a senior associate.
     
    There are two things that I believe make this case study unique:
    1. The first is the level of detail provided in the operating model, which allows the candidate to decide how much detail to include in their analysis. As an analyst or associate this is a common challenge. You will be bombarded with data (far more that what has been provided here), and you will need to identify what is important. It is your job to synthesize the information available into a cohesive narrative that will help the investment team make the appropriate decision.
    2. I also wanted to use this case study as an opportunity to introduce the legal documents that guide a transaction towards a close. The attached document describes all of the documentation required to secure a transaction under letter of intent. To complete this exercise you will have to pull information from two term sheets (one for a subordinated lender and one for a senior lender) and from a letter of intent. We have also included a massively condensed Confidential Information Memorandum to give you a better feel for how this process moves forward. If there is one thing I wish I had been exposed to earlier in my career, it is the significance of this documentation. Hopefully it will give you a leg up in interviews or on the job.

    These two variables make it possible to use this case study across a broad skill set. If you are a novice you can build a simple projection using the summarized financials available in the workbook. If you have a more advanced skill set you can use the information in the operating model to build a far more detailed model.

    We hope you find it useful!

    Please see the link that follows to download the associated notes and Excel workbook: LINK

     

     

 




 



Models are:
 
A) really boring
B) pretty sweet
C) super important
D) somewhat easy
E) kind of hard
F) fun
G) all of the above

 

 


*Answers a, b, c, d, e, f and g are all correct.