A Case Study in M&A Net Working Capital

Mergers and acquisitions are a fundamental part of growth strategies for many companies. According to Deloitte’s M&A trends survey for 2022, more than three-quarters of those surveyed agreed that M&A strategy is important–but the real star is the execution. 

As a deal moves forward, there are thousands of decisions, each requiring specific knowledge and experience. There’s a real risk of making a mistake either in pre-close planning or post-close integration that threatens to undermine the initially solid M&A strategy driving thousands of deals every year.

That’s where support from a skilled advisory team can really shine. At Embarc Advisors, we worked with an industrial equipment company through sell-side due diligence. In the process, the buyer took a traditional approach to calculate the net working capital targets–a choice that ultimately cost the buyer an additional $2M at closing. 

This case study serves as an important reminder that NWC targets are complex, and sometimes, traditional methodology may not be appropriate. 

Negotiating Net Working Capital Targets or Pegs

An NYSE-listed public company buyer was looking to expand their service offering into a specific niche by acquiring an industrial equipment company. The buyer had a Big 4-trained CPA serving as their Chief Financial Officer, so they had experienced, top-notch talent leading the transaction.

When it came to discussing the net working capital (NWC) target, this CFO insisted on a textbook approach using a 12-month average to calculate the NWC target. This is common, but there are also many situations in which a textbook approach isn’t the best option.

In this case, the target company had several distinct characteristics that made a strong case for customizing the NWC target calculation. For one, they had a well-established practice of collecting customer deposits in full before shipping. In other words, they had a negative net working capital, which was gradually dissipating as the company was fulfilling customer orders. 

The 12-month target calculation immediately resulted in a positive purchase price adjustment to the seller. This means that the buyer would pay more than the previously agreed-upon purchase price at closing. So, while it was a great outcome for our client, the seller, it wasn’t ideal for the buyer.

The buyer ended up paying $2M over the original sale price simply because they fumbled the NWC target calculation. 

This is a significant adjustment for a $50M transaction, more than the total fees paid to the buyer’s investment bank. It was a great win for our client, the seller, but it could easily have gone the other way. 

How a Custom NWC Target Might Have Changed the Outcome

While the buyer’s CFO was a trained accountant with a strong understanding of accounting concepts, the role of NWC from a deal dynamic perspective is complex. We have found that effective NWC target negotiations require a deep understanding of accounting, finance, and operations. 

Had we been on the buy-side, we would have taken a customized approach that strongly argued to recategorize some items as debt-like items along with a shorter time frame average, which would have materially impacted the NWC Target and the outcome at closing.

For example, the seller routinely collected deposits prior to ordering parts and commencing assembly of the finished product. This altered the typical accounts receivable cycle, frontloading the cash on hand. In other words, the advance deposit becomes a liability as the company owes the customer goods or services.

While the customer deposits are “current liabilities” and fall in the typical definition of NWC, one could argue that these are “debt-like items”  or debt-like obligations to customers. In this context, the buyer could make the argument that these liabilities should not be included in the NWC target calculation and rather be categorized as part of the debt-like items. Doing so likely would have benefited the buyer.

In this case, customer deposits were considered part of NWC, so they decreased the NWC level. As the company was growing and fulfilling customer orders, their deposits were exhausted, and the net working capital steadily increased. 

Setting the NWC target based on the 12-month average resulted in an artificially lower NWC target relative to the current level. Given the operational dynamics and the financial implications, we would have approached this with something closer to a 3- month average.

The treatment of customer deposits as NWC combined with the 12-month average resulted in a very low net working capital target. However, the working capital at closing was much higher than the 12-month average. This difference resulted in a cost to the buyer of an additional $2M at closing. 

An oversight like this is typically discovered in the very last stage when the fund’s flow is calculated based on the agreed-upon NWC target. At this point, the purchase agreement is already in place, and there is little that can be done to correct the mistake without derailing the transaction.

How Embarc Advisors Helps Businesses Navigate NWC Target Negotiations

At Embarc Advisors, our number one goal is to make M&A advisory accessible to small and medium-sized businesses. Through a curated team of varied expertise, we provide a diverse perspective on all aspects of mergers and acquisitions. Net working capital is one of the most complex and difficult aspects of a deal. It requires an intimate knowledge of accounting and finance, combined with a deep understanding of deal dynamics. 

Our team, which brings together experience from Big 4 Accounting, Investment Banking, and Private Equity firms, is uniquely positioned to set the right target level and effectively negotiate on behalf of our clients. 

Every business–and every deal–is unique. We consider all of the variables in NWC target negotiations and always take a tailored approach that reflects the target company and the deal dynamics. Having successfully executed several deals both on the buy-side and the sell-side, we are adept at communicating and negotiating these complex matters. 

Whether you’re acquiring or selling, the right advice from an experienced advisory team can make a big difference. In this case, it might have saved the buyer $2M. 

Contact Embarc Advisors today and take the next step toward growth.