Net Working Capital and Key Considerations for Buyers and Sellers Contemplating a Transaction

A key component of M&A transactions is the determination of a net working capital (“NWC”) target when a transaction closes. For financial statement reporting purposes, NWC is broadly defined as a business’s current assets minus current liabilities as reflected on the balance sheet.  Current assets include cash and other assets, such as inventory and accounts receivable, that convert to cash within a normal operating cycle (typically defined for most companies as one year).  Current liabilities include short-term liabilities, such as accounts payable and accrued expenses, which are due to be paid in cash within the one-year operating cycle.  

 

NWC is designed to measure a company’s cash generating capabilities and identify those current assets and current liabilities that impact the cash conversion cycle. The buyer/investor’s intent is to take over the business with an adequate level of normalized NWC on Day 1 to run the business without interruption or an additional investment of capital over and above the purchase price resulting from a shortage of NWC at closing. Conversely, the seller is looking to receive any excess NWC available at closing over and above a mutually agreed normalized NWC peg, which, in substance, is a positive adjustment to the overall purchase price. 

 

The calculation of NWC in an M&A transaction can be complicated and is a highly contested deal term that is usually left to the final negotiations and just prior to execution of sale and purchase agreements (“SPA”). There are key NWC considerations that should be identified and communicated by both buyers and sellers early in the transaction cycle before a letter of intent (“LOI”) is signed (or after the LOI is signed but prior to commencement of buyer financial due diligence) which can be accomplished through conducting a normalized net working capital analysis.  A thorough analysis of NWC is especially important for a buyer, as it mitigates the possibility that the seller can manage NWC in the periods leading up to a transaction by liquidating current assets into cash and leaving the buyer with insufficient NWC to run the newly acquired business on Day 1 post-close.

 

The following is a partial list of representative – but not all-inclusive – considerations that should be thoroughly evaluated by a buyer and seller as relates to normalized NWC:

M&A transaction NWC can include or exclude specific assets and liabilities unique to the transaction terms in an SPA.  NWC is generally defined as cash-free, debt-free because the intent is for the seller to retain ownership of available cash balances after settling outstanding debts and debt-like items and making available a normalized level of NWC at closing (exclusive of cash and debt).    Additionally, most M&A transactions include a NWC peg, which defines the amount of normalized NWC that would need to be delivered at the close of a transaction. 

Most SPAs include a requirement that a seller deliver a normalized level of NWC at transaction close to help protect, and the buyer that the acquired business will be in a healthy financial position to continue when they take ownership. The NWC peg is an agreed-upon amount of adjusted NWC that a seller of a business would be required to deliver at transaction close. The peg is most often determined based on a methodology and definition of inclusions and exclusions generally identified by the seller pre-LOI during the quality of earnings (“QOE”) process and the buyer post-LOI during the buy-side due diligence process.

 

In an M&A transaction, the peg is typically calculated by averaging a business’s pro forma adjusted NWC over the most recent twelve-month period which mitigates the impact of seasonality and provides a view of a normalized level of NWC necessary to maintain current operations post close. Additionally, a twelve-month NWC average is aligned with most buyer valuations of businesses which typically measure the enterprise value based on a trailing twelve month (“TTM”) normalized EBITDA, or, in more limited cases, based on TTM revenue, gross margins, cash flow or some other financial metric. However, the length of time that the average NWC is calculated is a negotiated item and can vary based on the business cyclicality, seasonality and other factors impacting the business resulting in a longer period (e.g., 24 months) or shorter period (e.g., three or six months) of time. 

 

The NWC can have a dollar-for-dollar impact to the purchase price or could be subject to limitations of a negotiated NWC “collar” or “bucket.”   For example, if the NWC peg is set at $5,000,000 by the parties, and the calculation of actual NWC at closing is $5,500,000, there would be additional purchase-price consideration to the seller relative to the excess NWC of $500,000. On the other hand, if the NWC peg is set at $5,000,000 and the calculation of actual NWC at closing is $4,500,000, there would be a negative adjustment to the purchase price of $500,000, resulting in the seller receiving $500,000 less in final closing proceeds. This dollar-for-dollar impact results in motivation for buyers to calculate the NWC peg as high as possible and sellers’ goal to calculate a NWC peg as low as possible. In select transactions, the parties agree to a “collar” or “bucket” such that if the difference between the NWC peg and actual closing NWC falls within the range set in the collar/bucket, then the parties agree not to make any adjustments to the final purchase price. This mechanism is intended to allow the parties to finalize negotiations and close the transaction without confrontation over relatively immaterial differences when compared to the overall purchase price of the company. Ultimately, the goal of determining a normalized NWC peg should be set at an amount that is fair to both the buyer and seller, represents a normalized level of NWC required to run the business on Day 1 post close, and ultimately results in no adjustment to the final purchase price. 

The NWC peg is calculated to deliver a normalized level of NWC on the transaction close date and is calculated consistent with the methodology disclosed and scheduled in the SPA. Some of the more common examples of NWC adjustments are listed below:

• Debt and debt-Like Items: If a transaction is structured as a cash-free/debt-free transaction, items defined as cash or debt would be excluded from the calculation of adjusted NWC and treated as an adjustment to the purchase consideration (e.g., outstanding debt would be calculated as a reduction to the cash proceeds to the seller).  Debt could be in the form of financial debt, such as a line of credit, capital leases, or other financial debt but could also include debt-like items, such as customer deposits, deferred revenue, income tax liabilities, accrued bonuses, or other deferred employee liabilities.  These debt-like items, which are generally identified during buy-side due diligence or imputed by a buyer based on their expectations or negotiation strategy, would be highlighted in the LOI and defined/scheduled in the SPA.  Cash balances would typically be reduced for outstanding checks.  Close attention should be paid to the classification of debt and debt-like items because of the direct dollar-for-dollar impact they have on the calculation of adjusted NWC and the purchase price.
• Cash to accrual considerations:  If the seller is on the cash or modified accrual basis of accounting, a conversion to full accrual GAAP basis accounting may be required. Additionally, if the seller makes certain adjustments only for fiscal year-end closing or audit purposes, those adjustments may need to be rolled back and reflected monthly to calculate an accurate average peg over the mutually agreed peg period. The conversion of the basis of accounting for financial statement reporting purposes to a monthly basis can take a significant amount of effort and time (and potentially might not be quantifiable due to lack of available monthly information such as inventory or deferred revenue calculations), which should be considered early in the transaction.
• Exclusion of certain other non-recurring and non-operational items included in current assets and current liabilities, such as transaction fee payables and personal items.
• Consideration of the quality of assets and normalization, which may result in the exclusion of aged receivables, payables, contra-assets (customer credits), contra-liabilities (vendor credits), or inventory (consignment inventory, direct ship inventory, inventory “on the water,” etc.) for purposes of calculating the NWC peg. Additionally, consideration should be given to possible excess inventory or receivables resulting from a change in a seller’s business model or payment terms with customers and vendors.
• Related party transactions and the impact of historical transactions not consummated on a fair market basis.

A detailed definition of the methodology, components, and calculation of NWC, as well as the accounting principles to be applied when calculating closing NWC, should be defined in the SPA. Careful attention should be focused on a clear and detailed definition of key NWC components such as debt, cash, and eligible accounts receivable, inventory, and deferred revenue. The accounts included/excluded could be included as a spreadsheet or schedule attached as an exhibit to the SPA. The calculation should include a calculation of how the peg was established as well as any estimated NWC adjustments (subject to true-up to actual NWC post-close) that should be included in the closing NWC calculation. The accounting principles included in the SPA should include the specific accounting policies, principles (e.g., GAAP), and methodologies to be applied in calculating the NWC peg and closing NWC. 

 

Many of these key NWC definitions, methodologies, and bases of accounting can be clearly articulated in the LOI which would help mitigate disagreements of NWC peg and closing calculations at a later, more delicate stage in the negotiations. Many transactions have been delayed or terminated due to relatively last-minute disagreement on the elements of NWC or the resultant immaterial amounts of NWC that could not be agreed by the parties pre-closing. Such unfortunate results could be avoided by more careful attention paid to communicating and disclosing the general intent of the parties upfront when the LOI is executed.

Understanding and accurately defining and developing a workable NWC methodology and tracking and calculating NWC on a real-time basis is a critical element of an M&A transaction. Developing a NWC peg that is mutually acceptable to the buyer and seller requires an upfront and clear definition of NWC in the term sheet, LOI and SPA to help avoid transaction delays and potential future NWC disputes. Buyers and sellers should strive to include sufficient descriptive language in the LOI, including the components of NWC, basis of accounting for calculating NWC, and inclusions/exclusions for calculating a normalized NWC PEG. It is important that both the buyer and seller analyze and understand NWC as early as possible in a transaction to avoid untimely and expensive NWC negotiation surprises -- including the potential for terminated transactions -- over issues that could have been avoided with timely attention and diligence early in the transaction lifecycle.