Working capital is one of the most hotly negotiated areas in a potential transaction. Furthermore, it frequently is the subject of post-transaction disputes and litigation. As the lifeblood of a business, working capital levels are in a constant state of flux. As a result, it can be very difficult to clearly define all of the specific working capital components that may impact the economics of a transaction. Whether you are a buyer or a seller, it is important to understand the impact of working capital on your transaction so that you can ensure you are getting a fair deal.
While most deals specifically define the components of working capital in the underlying deal documents, the most common starting point is to calculate working capital on a cash-free, debt-free basis and exclude income tax-related assets and liabilities, as reflected in the formula below:
Net working capital = current assets (excluding cash and tax-related assets) – current liabilities (excluding debt and tax-related liabilities)
Although the formula appears to be straightforward, there are countless ways each current asset and liability can be defined and interpreted in the context of a deal. In addition, buyers and sellers may have differing opinions about how working capital items should be treated for the purposes of the transaction. In order to avoid any surprises near or even after deal close, it is important that the parties understand the structure of the deal relative to working capital early on in the deal process.
Due to the ever-changing nature of net working capital, it is wise for the parties to agree on a net working capital target (“NWC Target”). The NWC Target is a level of net working capital that should be delivered by the seller to the buyer at closing. Any difference between actual net working capital at closing and the NWC Target is reconciled and, depending on the deal specifics, often leads to an adjustment of the purchase price.
The NWC Target is calculated based on a historical average (typically 12-24 months). However, the period used to set the NWC Target may differ from deal to deal depending on a number of factors. The following factors are commonly considered when setting the NWC Target:
- Seasonality: In certain industries, working capital will fluctuate during the course of the year based on business activity. It is important to note that certain industries may experience significant fluctuations based on the time of the year. As such, the parties should consider seasonality in setting the NWC Target as a straight historical average may not be indicative of the necessary level of working capital to operate the business on the closing date.
- Growth: If a company is experiencing rapid growth, it may need more working capital to fund operations and continue to expand. In setting the NWC Target, the parties may consider this anticipated growth and set the NWC Target at a level commensurate with those expectations. Generally, in this situation a 3-6-month period is used to set the NWC Target instead of a longer period, which will help to account for the recent expansion.
- Non-Operating Items: Depending on the company’s management and business model, they may not efficiently manage working capital. Non-operating assets left in the calculation could potentially inflate working capital. The company could also have related party assets and liabilities that would not continue post transaction and should be excluded in the net working capital calculation. As such, the parties should be mindful of what working capital accounts will be included in (and excluded from) the NWC Target.
A NWC Target can be a set number (“peg”) or a range (i.e., band). Similar to the NWC Target calculation considerations discussed above, there are a number of factors that will impact whether a peg or a range is used. The NWC Target serves as a protectant to both the buyer and the seller if there is significant shift in net working capital at close compared to the time at which the parties were negotiating the deal. The following examples illustrate the impact of a $400,000 to $600,000 NWC Target band:
- If actual closing net working capital is $300,000 (below the NWC Target of $400,000) – the purchase price would be adjusted downward because there is a shortfall between the working capital delivered by the seller and the NWC Target.
- If actual closing net working capital is $500,000 (within the NWC Target band) – the purchase price would not need to be adjusted.
- If actual closing net working capital is $700,000 (above the NWC Target of $600,000) – the purchase price would be adjusted upward because there is higher net working capital than agreed-upon by the parties.
In addition to the importance of setting a NWC Target, it is crucial for the buyer and seller to understand the period in which the deal will close. Because deals do not always close as of a fiscal year-end, the company’s month-end close process needs to be considered. Normally a month-end close process is not as involved as a year-end close. As such, the month-end financial statements may not be as reliable as a year-end set of financials (which may be reviewed or audited by an external CPA). Below are a few net working capital accounts that may need to be adjusted, along with related issues to watch out for:
- Accounts Receivable: It may be appropriate to adjust accounts receivable for uncollectible items or those that are aged over 90 days. It is also important to understand the company’s bad debt reserve calculation and ensure it is reasonable. For many companies, collectability is monitored closely at year-end, but may not be scrutinized at interim dates. This may result in uncollectable accounts receivable being included on the balance sheet, ultimately skewing the net working capital analysis.
- Inventories: An assessment of slow moving and obsolete inventory should be made before a potential transaction to ensure the inventory balance reported on the company’s financial statements is reasonable. Adjustments to the company’s inventory reserve also may be necessary. Because inventory may only be counted once a year, there is risk that inventory shrinkage may adversely impact the buyer at close. It is important to understand the company’s internal accounting processes in order to assess the risk associated with inventory balances.
- Payables: When considering payables in the context of a deal, it is important to determine if there are any unrecorded liabilities that should be considered in the net working capital calculation to ensure current obligations are fully reported. Payables may be understated as a result of delaying the entry of vendor invoices. Understated payables can skew the determination of the NWC Target and closing net working capital.
- Accruals: Similar to payables, it is important to ensure all relevant accruals are booked as of month-end. Both parties should understand the monthly process for accruals and whether all of the obligations were properly accounted for in the correct period.
The above accounts are the most commonly debated areas when negotiating net working capital in the context of a deal. In order to ensure a smooth deal process, it is important that both parties understand the key factors that ultimately drive the economics of the transaction. Thorough due diligence procedures and agreement of both parties on each of the components is essential in navigating working capital as well as the overall transaction process.