Dena Jalbert
Dena Jalbert is the founder and CEO of mid-market investment bank Align Business Advisory Services.

Net Working Capital is one of the most hotly contested items we see in M&A transactions. It is often addressed near the closing of a deal when emotions are running high, which tends to amplify the confusion and anxiety surrounding it. Whether you are a buyer or a seller, preparing for a situation like this before entering a transaction will help ensure a successful outcome at the negotiating table.

Most lower-middle-market (“LMM”) transactions are structured as asset transactions and are cash-free, debt-free. What that means is that the buyer is purchasing specific assets of the business, except for the cash in the bank and any debt. When a buyer makes an offer for a business, it assumes it is buying a specific set of assets, which includes working capital items. Working capital is defined as current assets less current liabilities.

A buyer assumes it will receive a specific amount of working capital, and oftentimes a working capital threshold is set to ensure that the amount of working capital they believe they will get is delivered post close.

The net working capital threshold is often addressed at the beginning of a transaction. The Letter of Intent (“LOI”) usually outlines the approach to be used for calculating and measuring the working capital. The challenge at this stage, however, is that financial due diligence has not yet taken place. This means buyers are not able to set the appropriate working capital threshold in the LOI.Therefore, we normally see language in LOIs that state something to the effect of, “working capital threshold will be determined using a mutually acceptable methodology which will be ultimately determined during financial due diligence.”

The Overall Importance of Working Capital

Working capital has a potential dollar-for-dollar impact on purchase price. Any adjustment to the purchase price is calculated by comparing the estimated working capital at close (based on the closing balance sheet) with the pre-determined working capital threshold. If the working capital at close is higher than the threshold, the buyer may pay the seller the incremental amount, which effectively increases the purchase price. If closing net working capital is lower than the threshold, then proceeds are withheld at closing to satisfy the deficit, effectively decreasing the purchase price. Therefore, net working capital delivered at transaction close impacts the cash that is paid or received by the buyer or seller and is an important factor to consider when maximizing the value from your transaction.

Example: Net Working Capital at Close Calculation

Scenario A:
Net working capital at close $5,000,000
Net working capital threshold $4,000,000
Working Capital Excess (deficit) $1,000,000
In this scenario, the buyer will pay an incremental purchase price of $1,000,000 as the seller delivered a net working capital at close that is higher than the threshold.

Scenario B:
Net working capital at close $3,000,000
Net working capital threshold $5,000,000
Working Capital Excess (deficit) ($2,000,000)
In this scenario, the seller will leave $2,000,000 of cash behind to cover the deficit. This can come from the cash on the balance sheet, or the overall purchase price is decreased by $2,000,000.

How is the Working Capital Threshold Calculated?

A net working capital analysis is performed in due diligence and is reviewed and agreed upon by both parties. The intention is to mitigate any disputes over working capital. The threshold is typically calculated as an average of the net working capital on the balance sheet for the past 12 months. Twelve months is the most-used timeframe as it incorporates any seasonality a business may experience in its cash flows.

Working capital is the net of current assets and current liabilities. Because most deals are on a cash-free, debt-free basis, cash is excluded from current assets. Current assets would include (but are not limited to) things such as accounts receivable, deposits, prepaid expenses, and inventory. Current liabilities would include (but are not limited to) things such as accounts payable, accrued expenses, customer deposits, and deferred revenue.

The definitive purchase agreement will define the details of how net working capital is calculated, and the calculation will be presented in a disclosure statement to the purchase agreement. The definition clearly states what account balances are included or excluded from net working capital.

How Can I prepare for Net Working Capital in My Transaction?

The analysis performed on net working capital is the basis upon which the detailed definition of net working capital is in the definitive purchase agreement. Therefore, the first (and best) thing you can do is ensure that all of your balance sheet accounts are properly reconciled and up to date. Below are some common accounting and balance sheet items that can affect the calculation:

Cash versus accrual accounting: Most LMM businesses are on a cash-basis and are driven by taxation. Oftentimes working capital is restated using the accrual basis to match revenue, expenses, and free cash flow more properly.
Aged Accounts Receivable: Many LMM businesses don’t make a habit of writing off uncollectible accounts. It’s important to go through your open accounts receivable and make sure that everything is collectible. If Accounts Receivable is overstated in the working capital at closing, there can be a claim made against the escrow post-close, reducing overall purchase price.
Obsolete inventory or incorrect inventory counts: It is important that companies regularly count and verify their inventory to ensure their balances are up to date. If inventory is overstated, there could be a shortage post-close that results in lost sales, and a claim could be made against the escrow, reducing overall purchase price.
Deferred revenue: When customers prepay for goods or services, most LMM businesses recognize revenue when the cash is received, as they are normally cash-basis. However, because the goods and services have not been delivered, that revenue (and cash) isn’t technically earned. This means the buyer will have to provide the good or service post-close. A liability would need to be established for customer deposits or advanced collections.
In the end, if you are unsure whether you have captured all aspects of working capital properly in your financials, it is a good idea to consult with a management accountant who can help reconcile your accounts and ensure proper accounting compliance. Doing so in advance will likely save you time, headache, and most importantly, meaningful dollars in the future.