Net working capital (NWC) plays a critical role in executing M&A transactions, as it influences the closing purchase price and the transition of operations from seller to buyer. NWC represents the difference between a company’s current assets (e.g., cash, accounts receivable, and inventory) and its current liabilities (e.g., accounts payable, accrued expenses, and short-term debt). While it may appear simple on the surface, NWC issues can be a significant roadblock in closing a transaction. First, we need to understand why NWC matters in M&A deals.
Importance of Net Working Capital
NWC directly affects the closing purchase price. Buyers and sellers negotiate a target net working capital amount to be delivered at the closing date (commonly known as the “Peg”) during financial due diligence. The average monthly NWC during the trailing twelve-month period is the most common method for determining the Peg. Understanding NWC inclusions and exclusions also helps refine the definition of working capital and indebtedness in the final purchase agreement.
A comprehensive NWC analysis during financial due diligence can minimize disputes at closing and post-transaction. Additionally, a complete NWC analysis and understanding facilitates a smooth transition of operations from seller to buyer and prevents additional costs.
NWC provides a clearer picture of ongoing operating expenses. Buyers use it to evaluate the acquisition’s financial sustainability and assess NWC to understand the working capital required for operations after the deal closes, avoiding unexpected cash infusions.
In M&A transactions, net working capital is not just a financial metric, it is a strategic lever. Buyers and sellers must collaborate to strike the right balance, ensuring a successful deal and a healthy business moving forward. Next, we will discuss common pitfalls when evaluating NWC.
Common Pitfalls of Net Working Capital
Clear communication and agreement on NWC targets and definitions between buyers and sellers are essential to avoid surprises down the line. It is important to clearly establish any adjustments to NWC during financial due diligence. Parties may dispute adjustments based on materiality thresholds. Establishing clear limits for adjustments helps prevent unnecessary conflicts.
Incomplete or inadequate current assets and liabilities are another pitfall of NWC. Sellers must ensure that all relevant current assets (such as accounts receivable and inventory) and current liabilities (such as accounts payable and accrued expenses) are included in NWC calculations and are properly valued. Overdue or long outstanding customer receivables should be evaluated for collectability or potential reserve balance. Inventory that is unsellable due to age, impairment, or other factors can cause disputes. Sellers may want to include such inventory in the closing NWC, while buyers should argue for its exclusion. Overdue and long outstanding payables should be evaluated for sustainability post-transaction, or more likely, treated as debt as part as part of the closing. All incurred expenses should be properly accrued through the closing date, so there are no surprise payments owed by buyers post-transaction.
Buyers typically acquire the target company on a cash-free and debt-free basis. This means they do not assume cash or debt; both remain with seller. Sellers should be aware that cash in the business is typically excluded from NWC, and any outstanding debt must be paid off upon closing. Navigating these pitfalls ensures a smoother M&A process and better outcomes for both parties. Lastly, here is an example of how NWC can affect the purchase price.
Scenario
- Company A is acquiring Company B.
- The agreed-upon purchase price, commonly known as Enterprise Value is $100 million.
- The NWC target (or “Peg”) is set at $10 million.
- Company B has $5 million in cash and $3 million in debt.
- NWC at close is $12 million.
Calculation*
Net Proceeds of Sale = Enterprise Value + Cash – Debt + NWC at Close – NWC Target
Net Proceeds of Sale = $100 million + $5 million – $3 million + $12 million – $10 million
Net Proceeds of Sale = $104 million
The difference between the closing NWC and the target is $2 million ($12 million – $10 million), resulting in an increase to the closing purchase price. Alternatively, if the closing NWC was only $8 million, this would have resulted in a downward adjustment to the purchase price of $2 million.
NWC is often an underappreciated component of an M&A transaction; however, given its direct impact on the purchase price it is critical to have the right advisors in place to prevent unforeseen issues and unnecessary headaches at the finish line of an M&A transaction. With the right advisors in place, a smooth transition can achieve a fair result for buyers and sellers.
*Note: This is a simplified example for illustration purposes. In practice, additional factors and negotiations may come into play.
Author: John Schrumpf, CPA | [email protected]
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