Here’s a Different View
There’s an old saw in life that where you stand, depends on where you sit. In other words, someone with a vested interest in something is more likely than not to support and represent ideas beneficial to that interest. And that’s what crossed my mind as I began reading “The Relationship Between Deposits and Net Working Capital,” an article that Emily passed along to me over the summer.
Because “Aha!,” I said, as I read that “During transaction negotiations, buyers often argue deposits on a seller’s balance sheet should be treated as debt. This perspective is seldom accurate.” The person writing this article must be on the sell-side having represented customers who take customer deposits. And yes the author Brian Basil works for investment bank Crewe Capital, “understands all of the nuances of working capital,” and invites readers who might be selling their businesses to contact him.
The question here is around what assets and liabilities stick with a company after a transaction and which remain with the seller. But rather than start by getting bogged down in accounting terms and definitions, let’s start from first principles. Our view is that whether we are buyers or sellers, when it comes to balance sheets, companies should retain the assets and liabilities necessary to create the value for which the seller has been compensated and that the seller should retain that for which it has already been compensated.
Let’s start with an easy one…
Consider a seller that took out a $5M loan and then used the proceeds from that loan to pay itself a $5M dividend. In the event of a transaction, since the seller received the value of that debt, the seller should retain the obligation to retire it. Easy, like I said.
Now, take a payroll obligation. Basil argues that “payroll is not considered debt in the context of a transaction because it is incurred as a normal part of business operations and settled at regular intervals. Thus, payroll is almost always included in the definition of NWC.” While that may be the experience of Crewe Capital, it’s not our experience. We never include payroll in the definition of net working capital.
See, a good way to test the validity of an argument is to see if the logic of it holds at extremes. For example, let’s consider a company where payroll (like, say, a performance bonus) is accrued, but only paid out every year, and let’s further assume that a transaction occurs one week before that payroll is to be paid. Should the buyer be responsible for retiring that obligation?
Our answer, using a first principles approach, is clearly no because all of the value generated from accruing that payroll obligation went to the seller in the form of inflated cash flow. Therefore, the seller should use the proceeds from that inflated cash flow (or the deal) to pay it off. While the argument that payroll is a normal part of business operations settled at regular (usually lesser) intervals, makes this typically a less material amount, since the seller received the benefits of the work, the seller should ultimately pay for it.
And that brings us to customer deposits, which I’ll agree with Basil is a nuanced issue. By establishing the straw man that things that are a normal part of business operations settled at regular intervals should be included in net working capital calculations, he goes on to posit that deposits meet those criteria. But think about deposits from first principles…
Deposits are money a customer pays a company in advance for a product or service. The company can then use that cash to deliver the product or service and keep the profit. But if it distributes all of the cash that it needs to deliver that product or service, it can’t deliver that product or service and is therefore bankrupt. And no one wants to invest in a bankrupt company.
So our middle ground view on customer deposits is that the seller can keep any expected profit associated with the deposit since it originated the sale, but that the company should retain any cash necessary to fulfill the product or service obligation, since it has to do the work. In other words, the seller keeps the value, but also retains the obligation. There’s no fair world in any situation where you keep the value and shed the obligation (other than some recent public policies, but I digress).
A good question here is why are these things different from typical working capital items such as accounts receivable, inventory, and accounts payable? Our answer to that is that unlike deposits, which create obligations in the future, and payroll, which clearly created value in the past (and both to the benefit of the seller), AR, inventory, and AP are liquidity related items that happened in the past but that roughly offset one another in the future as determined by the observable cash conversion cycle of the business. To put that another way, they are known knowns that can be estimated and quantified and are retained by a business in order for it to operate in normal and ordinary course going forward.
Another counter argument I’ve heard (and that Basil makes) is that if customer deposits are part of the business model then deposits from hypothetical future work should be able to fund historically obligated work. And while that math can look good on a spreadsheet, those are, well, the mechanics of a Ponzi scheme. And no one wants to invest in a Ponzi scheme.
– Tim
