Navigating Working Capital Challenges in M&A Transactions

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NWC, Transaction, Working Capital

Understanding Working Capital and Net Working Capital

Working Capital (WC) is defined as Current Assets (CA) minus Current Liabilities (CL), amounts that are reflected on a company’s Balance Sheet (B/S). CA typically includes cash and cash equivalents, Accounts Receivables (A/R), Inventory, Pre-Paid Expenses. CL includes Accounts
Payable (A/P), Notes Payable and other Accrued Liabilities. The WC reflects a company’s liquidity level for managing its day-to-day expenses. Net Working Capital (NWC) is the result of subtracting the total of CL from the total of CA. If the NWC is positive, then the company is self- sustaining and does not require any outside capital. If the amount is negative, then the company will need to infuse, or borrow capital (e.g., from a line of credit) to support its day-to-day business needs.

The Significance of Working Capital in M&A Transactions
When acquiring a company as a going concern, the buyer’s offer will typically require a certain level of NWC to be left in the company to sustain the business operations post-transaction. This avoids the situation in which the buyer pays an amount for the company at closing, and then
needs to invest more capital into the business to maintain its operations post-transaction. When determining this minimum NWC level or “Target NWC”, the buyer will look at the past three-, six- and twelve-month NWC averages to determine a reasonable amount. The purpose of a NWC target is to make sure the business remains a going concern on its own post-transaction, and not to necessarily financially benefit the seller or the buyer in a transaction. With that said, determining a reasonable NWC target can become a separate negotiation once the buyer
completes its due diligence as there may be discrepancies between the seller and buyer’s perspectives on the value of certain assets and liabilities. Here are a few examples of issues that may require a negotiation when determining a Target NWC in an M&A transaction:

  1. Agreeing to the NWC Amount: While the concept of calculating CA – CL may seem straight forward, buyers may challenge the value of certain CA such as Accounts Receivables (A/R), particularly if the A/R includes amounts that are more than 90 days past due. Alternatively, there may be certain CL that are not shown on the B/S, or are not current, such as Accrued Benefits. Also, certain buyers may submit an offer that is “cash free/debt free”. This means that the amounts for Cash/Cash Equivalents and Notes Payable will NOT be included in the NWC calculation, as they will be assumed to not be a part of the deal. Each item that is included in the NWC calculation will need to be agreed upon by both the buyer and seller before the Target NWC can be defined and
    negotiations can be completed.
  2.  Seasonality and Industry Variances: If a seller’s company is impacted by seasonal or industry driven variances throughout a year, this can impact how the Target NWC affects the terms of a deal. For example, if a transaction closes at a time when the company is
    experiencing peak performance, the company’s B/S will be strong and its NWC will be high. This may mean that the seller receives additional value for NWC that exists in the B/S above the NWC Target at closing. Alternatively, if the transaction closes at a low point of performance, then the company’s B/S at closing may reflect a NWC that is below the Target NWC. This would require the seller to leave more in the B/S to meet the Target NWC amount.
  3. Adjustments Post-Closing: When a closing date is determined, often the seller does not have the information needed to create a final B/S as of the closing date. Therefore, the seller needs to provide the buyer with an estimated closing B/S, and the buyer and seller need to agree to a timeline for which the final B/S will become available – typically within 30 to 60 days of closing. The discrepancies between the estimate and final B/S result in post-closing adjustments, where either party may owe the other compensation to account for the variance. These adjustments can create disagreements, especially if the methodologies for calculating working capital levels were not clearly defined or agreed upon prior to closing.
  4. Other Items: Certain companies may have exceptions that impact their NWC calculations, such as trust accounts for clients, purchased portfolios of consumer or commercial debt, and/or pending or budgeted investments into IT and other business needs.

As a prospective buyer or seller, finding the deal opportunity is an important first step, but getting it closed is the ultimate objective. We at CAS have over 70 years of collective experience within the technology and technology enabled business services sectors. We are ready and available to address your M&A needs. Contact CAS to learn more today.

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