Capital – or the money that a company has access to – comes in many different forms. Depending on the context, this might include cash-on-hand, accounts receivables, assets, or other means of liquid or non-liquid funding.
One type of capital – net working capital is the difference between a company’s current assets and current liabilities.
This financial metric is what companies use to fund short-term liabilities. The value of net working capital also tells creditors, investors, and vendors a thing or two about the operational efficiency of the company.
For example, a high net working capital indicates that a business has a lot of cash tied up in accounts receivables and inventory relative to its short-term payment obligations (e.g., accounts payables).
How to Determine Net Working Capital (NWC)
How a business calculates net working capital, or NWC, might vary depending on the context. For business-as-usual, it would include a sum total of current assets (e.g., accounts receivables, inventory, prepaid expenses) minus current liabilities (e.g., accounts payables, deferred revenue etc.). Net Working Capital excludes cash and short-term debt (e.g., line of credit, revolver).
However, in M&A, not all current liabilities may be considered net working capital. Most private company transactions are structured as cash-free / debt-free transactions. This means at closing, the seller will keep any cash in excess of the debt amount, or the seller will have to pay any remaining debt.
In this context, some current liabilities may be categorized as a debt-like item and will be excluded from the NWC calculations. Therefore, determining net working capital in an M&A takes a different approach.
Current Assets (excluding cash & cash equivalents) – Current Liabilities (excluding debt & debt-like items) = Net Working Capital
The Role of Net Working Capital in an M&A Transaction
In most private company M&A deals, the letter of intent (LOI) will include something along the lines of:
“Company will be delivered with sufficient working capital defined as the current assets minus current liabilities excluding debt-like items minus cash. Prior to the close, Seller and Buyer will agree on a target level of working capital for the Company at close, and the Total Purchase Consideration will be adjusted for any difference between the target working capital and the actual working capital.”
As an advisor, I’ve heard a lot of NWC horror stories from founders that experienced unpleasant surprises as their deals closed. See, the last part of the agreement language states that the purchase price can be adjusted based on your working capital.
There are two things that you can do to ensure a seller is well positioned to navigate potential NWC boobytraps:
1. Properly Define NWC
2. Set the Right Target (or Peg)
The Purpose of the Net Working Capital Target
Business activities like payment activity and billing on accounts receivables or the sale of inventory fluctuates. These changes can make it hard to nail down a number for net working capital.
Defining a peg or NWC target is unique to business conditions and deal objectives. This means that both counterparties need to agree on a target and a mechanism for adjusting sale prices and deal terms based on this target.
This target ensures that the buyer has the capital needed to keep the doors open once the ownership is transferred. It also prevents gaming the system. For example, a seller cannot deplete inventory levels leaving the buyer to handle the fallout after the papers are signed.
If they do, the seller will be obligated to provide the necessary capital needed to make up the difference and meet the target. Conversely, if the seller delivers NWC above the target, they may receive additional compensation based on the target and the corresponding sale price mechanism.
How to Set the Net Working Capital Target
The textbook answer is that a standard net working capital target (or peg) should be set based on the last 12-month average. However, real business seldom follows textbooks.
Depending on the company, business environment, seasonality, operating practices, and structural changes, a customized approach may be required to set an appropriate peg that is “fair” to both parties.
Step One: Ensure that historical working capital accounts are normalized. Comb through the financials and remove any non-recurring impacts like inventory loss or customer default. A Quality of Earnings assessment can be instrumental in providing this view.
Step Two: Use the normalized run-rate view of the working capital as a baseline to negotiate a net working capital target. Together, the buyer and seller must agree on a level of working capital to be delivered at closing (i.e., Target).
From the Seller’s point of view, the lower the target, the better, as any excess at the time of closing will result in a positive adjustment. However, the Buyer, in an effort to mitigate risk, will try to set a higher target.
In the below example, the seller would prefer a target that is based on the trailing three-month average, whereas the buyer would prefer a 12-month average. The art of the deal will be in articulating why one makes more sense than the other.
Post-Close Net Working Capital Adjustments
The concept of a net working capital target is how an operating business addresses the variable nature of financial conditions during a sale. At closing, the seller estimates the amount of net working capital to be delivered to the buyer.
Then, in the 60-120 days post-closing, the buyer’s accounting team will compare the actual amount of NWC delivered at closing to the target, validate it, and finalize the purchase price adjustments. If the target is set too high, this will result in a negative adjustment to the Seller, i.e., the Seller will owe money to the buyer.
All-in-all, net working capital targets leave a lot open to interpretation. While they are variable by nature, they work to facilitate trust between counterparties. This obligation keeps the seller honest, preventing them from liquidating assets prior to a sale or aggressively collecting on accounts receivable to pocket the cash while leaving the bills outstanding.
But what happens when you get the NWC target wrong? Next, let’s take a look at the risks associated with inaccuracies in calculating NWC targets.
Risks Associated with NWC Targets
As you can imagine, working with NWC targets is a bit risky. When we’re dealing with estimations, there is a lot of room for error. That begs the question–what is the worst that might happen if we’re wrong?
The best-case scenario is that the numbers are close enough or that the methodology for price adjustments is clear enough that both parties walk away satisfied with the post-closing true-up of the net working capital.
What’s the worst-case scenario? The final numbers might be inflated by unnecessary costs. In one case, a fumbled NWC target cost a Buyer an additional $2M on a $50M deal. This could have just as easily gone the other way with the Seller realizing they ended up with the short end of the stick after the fact.
How to Prepare for the NWC Discussion in M&A
The NWC target discussion usually comes into play towards the very end of the M&A process – sometimes just a week before signing the deal.
Oftentimes sellers are exhausted from the diligence process, and the NWC target can slip through without receiving the attention it deserves because it is at the very end of the process. Skip the fatigue-fueled inattention by preparing for the net working capital target discussion at the beginning of the process. This starts with a seller’s quality of earnings (QofE) assessment.
Missing this important step can leave errors that present opportunities for financially savvy buyers to leverage.
Conduct a Sell-Side QofE
The quality of earnings, or QofE assessment, takes a detailed look at a company’s financial performance, including past and present variables, to determine the normalized run-rate financials that drive the value of a company.
The QofE sets the foundation for financial analysis, including the forecast, which in turn drives valuation. The QofE is also the primary tool to analyze the NWC and set the target. When it comes to net working capital, the QofE plays an important role in cleaning up inaccuracies and missing information so that the NWC target is a fair representation of true working capital needs.
This translates to fewer surprises and a smoother transaction leading up to the closing and as the NWC is trued-up post-closing. Most importantly, it ensures that the Seller does not have any nasty surprises at the very end of the process or even post-close.
Perform a Near-Closing Inventory Count
Provide the most up-to-date and accurate information available. A near-closing inventory count may locate products in secondary storage or eliminate obsolete inventory that will impact the post-closing true-up.
Use Consistent Language and Illustrative Examples
Be intentional about how and when the net working capital is discussed in pre-closing communications and legal documents. Avoid conflicting language or ambiguity in explanations that might leave gaps. Just like the example above, if the counterparty is facing an unanticipated loss, they will look for leverage, like language that can be open for interpretation.
The Bottom Line on Net Working Capital in M&A
Net working capital is an important part of operating a business. It’s the funds that keep the doors open (or pay short-term liabilities). And in mergers and acquisitions, it’s a number that gets a lot of attention because the deal involves a real, live business.
Selling or buying a business takes months. During that time, cash on hand, accounts receivable, inventory, and accounts payable fluctuate on a near-daily basis. To deal with the variability, the counterparties rely on a net working capital target typically calculated based on a set of unique factors.
Not only does the dollar value of the capital target change, but the method of calculation varies as well. All-in-all, it’s a recipe for disaster if it’s not carefully managed. Successfully negotiating the net working capital takes a broad skill set.
Embarc Advisors can provide a team filled with expertise in accounting concepts, the mechanics of calculating net working capital targets, and the art of negotiations. Contact us today and start planning for your next big move.
Learn more about working with an advisor in our post: Best Practices for Due Diligence Support
