Importance of Net Working Capital ("NWC") in M&A

February 2019


By Gen Oraa, Managing Director – Transaction Advisory Services, BDO USA, LLP

Is additional spending for legal and accounting fees post transaction worth resolving a working capital disagreement? How about the disruptive impact of management distractions and the related cost of a working capital dispute on operations? Buyers and sellers can avoid these potential challenges by performing a comprehensive net working capital analysis prior to closing a transaction.
 
A net working capital analysis is one of the key areas in financial due diligence, in addition to a quality of earnings analysis—i.e., adjusted EBITDA (earnings before interest, taxes, depreciation and amortization)—and a debt and debt-like items analysis. Each of these analyses may have a potential positive or negative dollar impact to the buyer or the seller as part of a transaction. Working capital is generally defined as current assets minus current liabilities, although it is a bit more complicated when you drill down on the specifics.
 
A buyer, which may be a private equity or strategic acquirer, generally addresses net working capital at the onset of a potential transaction. The letter of intent (“LOI”) generally outlines the approach for how net working capital will be treated in the purchase and sale agreement. The LOI may include a section stating a mutually acceptable methodology in calculating a net working capital peg, which would ultimately be determined typically during financial due diligence.
 
A seller, on the other hand, may also prepare a net working capital analysis to anticipate a buyer’s potential negotiating points. At the same time, the seller could use the information obtained from the analysis to develop tools to establish a defensive working capital mechanism with the goal of minimizing potential purchase price erosion. Keep in mind that the seller wants to deliver the highest level of working capital possible, while the buyer wants the lowest amount of working capital delivered. These dynamics should be considered during the analysis and negotiation phases.
 
Before diving into the mechanics of a working capital analysis, it is helpful to understand the overall importance of net working capital in the sale/purchase of a business. The following outline several benefits of performing a net working capital analysis:
 
  • Working capital has a potential dollar-for-dollar impact on purchase price, which involves the following:
    • Development of the average working capital peg or “the Peg”
    • Identification of debt and debt-like items
  • The definition of working capital and indebtedness in the purchase and sale agreement would be further refined by having a good understanding of working capital inclusions and exclusions
  • Avoidance of net working capital disputes and related management distraction and associated costs
  • Quality of current assets and completeness and/or adequacy of current liabilities
  • Cash/financing requirements for operations post transaction
 
Dollar-for-Dollar Impact on Purchase Price
The working capital peg is generally one of the key considerations in purchase price adjustments. Such adjustment is preliminarily calculated by comparing estimated net working capital at transaction close with the pre-defined peg. If the closing net working capital is higher than the peg, the buyer may pay the seller an incremental amount, dollar-for-dollar, which effectively increases the purchase price. If the closing net working capital is lower than the peg, the buyer may pay a lower amount, dollar-for-dollar, which effectively decreases the purchase price. Net working capital delivered at transaction close impacts the cash that is paid or received by the buyer or the seller.
 
Illustrative Calculation – Net Working Capital at Transaction Close Versus the Peg
Scenario A – Buyer “Pays”
Net Working Capital at Close                            $ 22,500,000
Net Working Capital Peg                                       20,500,000
Excess NWC - Buyer Pays the Seller                 $   2,000,000
 
In Scenario A, the buyer will pay an incremental purchase price of $2,000,000 as the seller delivered a net working capital at close that is higher than the Peg.
 
Scenario B – Seller “Pays”
Net Working Capital at Close                            $ 18,500,000
Net Working Capital Peg                                       20,500,000
Shortfall in NWC - Seller Pays the Buyer         ($ 2,000,000)
 
In Scenario B, the seller delivered a net working capital that is lower than the Peg. In this case, there will be a potential reduction in purchase price by $2,000,000. The seller’s proceeds will be lower by the deficiency in net working capital delivered at close.
 
A net working capital analysis, which is generally used in determining the net working capital peg, is key in avoiding disputes as previously mentioned, among other things. So, what is a net working capital peg anyway? A net working capital peg or simply called the “Peg”, is a benchmark or baseline amount of net working capital that is agreed upon by the buyer and the seller and is usually determined toward the end of financial due diligence.
 
How is the Net Working Capital Peg Calculated?
Typically, the Peg is an average of a normalized and/or adjusted net working capital for the latest trailing twelve months. However, based upon the agreement between the buyer and the seller, the average period could be shorter, such as latest trailing six or even three months, if these periods better represent the current or even short-term future state of the target’s business. Further, consideration should be given to business seasonality/cyclicality, projections, and transaction close timing to help determine the anticipated level of net working capital at the time of transaction close.
 
As indicated earlier, the buyer and the seller have opposing interests when developing the Peg. The buyer would prefer the highest working capital peg possible, while the seller would prefer the lowest working capital peg possible. The common ground is for the net working capital transferred at transaction close to be sufficient for normal operations on day one and thereafter. Insufficient working capital delivered at closing might require the buyer to infuse additional cash into the business or increase its borrowing to operate the business post close.
 
In M&A, the Peg is one of the key negotiated items. The determination of the networking capital peg is both an art and a science. There is the mathematical component (current assets minus current liabilities) while also identifying normalizing, non-operating, and nonrecurring items in working capital. The normalizing, non-operating, and nonrecurring items are generally identified and quantified during the financial due diligence phase. The agreed upon working capital should be neutral to both buyer and seller and should reflect the true working capital needs of the business. Generally, there are three broad categories of net working capital adjustments:
 
  • Definitional Adjustments: These adjustments relate to the broad definition of net working capital based on a typical cash-free, debt-free transaction arrangement. These primarily include cash and financing related items such as line of credit and accrued interest, which should be excluded from net working capital.
 
  • Due Diligence Adjustments: These adjustments are identified based on the walkthrough of trial balance accounts and various analyses. Due diligence adjustments relate to non-operating, nonrecurring, and accounting methodology-related/normalizing items. Items such as proposing the accrual for payroll or bonuses where none existed before are examples.
 
  • Pro Forma Adjustments: These adjustments primarily relate to presenting the historical net working capital balances using a consistent methodology or assuming the same scenario “as if” they were being applied at the historical monthly balance sheet dates. This is where a retroactive impact is calculated and adjusted in the monthly balance sheet using a common assumption. An example would be a pro forma adjustment for a product category that was recently introduced but parties intend to reflect its working capital impact “as if” it was a product being sold by the target from the beginning. In this example, items to be considered for the pro forma adjustment include inventory and accounts payable.
 
The analysis performed on net working capital, together with the adjustments identified, serves as the basis for a detailed definition of net working capital in the purchase and sale agreement. The definition is articulated by way of stating clearly what account balances are included in and/or excluded from net working capital. In more specific terms, the following are typical considerations that may give rise to net working capital adjustments that should be considered when calculating the Peg:
  • Cash or accrual basis of accounting. This normally is considered in smaller transactions where record-keeping is on a cash basis and likely tax driven. Working capital may need to be recalculated using the accrual basis.
  • Difference between month end and year end accruals may impact working capital as significant year end true-ups may potentially impact not only EBITDA but also the average net working capital. The interim periods will not be representative of the consistent level of net working capital compared to year end balances.
  • Significant adjustments to EBITDA may impact working capital including one-time adjustments (no interim periodic adjustments), non-operating expenses including transaction-related professional fees and personal expenses, one-time reversal of accruals, nonrecurring revenue, and nonrecurring expenses such as severance expense.
  • Aged accounts receivable, obsolete inventory, aged accounts payable, non-operating accounts payable such as capital expenditures and transaction related balances (i.e., professional fees in connection with the sale of a business), income tax related liabilities, etc.
  • Related party balances that are not operating in nature or on payment terms that are not arm’s length.
  • Deferred revenue (i.e., advanced collections and customer deposits). In a cash-free, debt-free transaction, the buyer will have an obligation to provide services to customers post transaction while the related cash remains with the seller.
  • Normalization adjustments. Year end adjustments to certain working capital accounts were not performed during the interim balance sheet dates. The monthly balances may be adjusted to normalize all the months and calculate an average that is more representative of the working capital balance rather than incorporating the impact of a one-time, year end adjustment.
  • Pro forma adjustments are used to present net working capital using a similar assumption applied to the historical balance sheet dates, which may be retroactive or prospective looking. Such pro forma adjustments may include the impact of acquisitions and divestitures, significant/transformational production efficiencies or operational changes, revenue and cost synergies in the case of a strategic transaction, new products and/or services, accounting methodology, addition or elimination of executive positions, commission methodology, etc.
 
A comprehensive and robust definition of working capital and indebtedness in the purchase and sale agreement reduces the potential for litigation.
 
One of the key benefits of performing a net working capital analysis is having the ability to understand the nature of each of the accounts in current assets and current liabilities. This understanding facilitates the determination of whether an adjustment to net working capital should be made when establishing the Peg. The net working capital adjustments serve not only as a component in calculating the Peg but also a basis in providing clear language in the definition of net working capital and indebtedness in the purchase and sale agreement.
 
The accounting methodology (i.e., GAAP applied consistently or some other applicable language) should also be included within the purchase and sale agreement. In addition to the definitions, for purposes of clarity, a sample schedule calculation as an exhibit is recommended for inclusion in the purchase and sale agreement. The more detail each party agrees to about the calculation of and items included in working capital, the lower the likelihood of a litigation to occur post transaction. Consider that both the buyer and seller calculate the allowance for doubtful accounts differently and the seller’s methodology was used to develop the Peg. At post transaction close, the buyer presents an adjustment to working capital using their methodology for calculating the allowance for doubtful accounts, which results in an adjustment to decrease working capital. This scenario could result in a dispute if there was no clear definition of working capital accompanied by an exhibit showing how working capital should be calculated in accordance with the definition.
 
Certain of the identified working capital adjustments may impact the definition of indebtedness within the purchase and sale agreement. This occurs in cases where current liabilities include non-operating/financing related items such as a line of credit and accrued interest. Furthermore, certain current liabilities may be better classified as a debt-like item or long-term in nature such as accounts payable aged over one year, bonuses/accrued profit sharing, change-in-control payments, transaction related liabilities, one-time/non-operating EBITDA adjustments with a related net working capital impact, etc. Like net working capital, debt and debt-like items have a potential dollar-for-dollar impact on purchase price.
 
Quality of Current Assets and Completeness/Adequacy of Current Liabilities
Recorded balances for current assets and current liabilities in the target’s books and records may not accurately reflect their economic impact (for example; allowances against aged accounts receivable). Depending upon the target’s accounting methodology and estimation process for the allowance for doubtful accounts, aged accounts receivable, net of the allowance, may not necessarily be collectible in full. An additional amount to increase the allowance for doubtful accounts for adequate risk of collection coverage may be a potential net working capital adjustment. Such adjustment may not only impact the Peg but also provides a balance of accounts receivable that reflects what is truly realizable/collectible.
 
In terms of current liabilities, there may be liabilities that are understated or inadequate to meet practical obligations or simply not recorded in the financial statements. For example, in the case of self-insured medical coverage, the target relies on estimates to record both reported and unreported claims. If the methodology is flawed or uses inaccurate and/or untimely data, the related self-insurance liability may be understated or overstated requiring a working capital adjustment for purposes of calculating the Peg. Additionally, certain obligations may not be reflected in the financial statements simply because of the target’s materiality threshold or data not being available for quantification (e.g., environmental liabilities). In instances where the liability cannot be quantified, a buyer may still be able to protect itself by including in the definition of indebtedness the identified liability or include a provision in the seller’s representations and warranties as protection for the buyer.
 
Cash and Operating Requirements Post Transaction
Metrics such as days sales outstanding (“DSO”), days payables outstanding (“DPO”) and days inventory outstanding (“DIO”) collectively depict a company’s cash conversion cycle and are useful in estimating the amount and timing of cash flows. Be on the lookout for significant changes in these metrics over the last twelve months as you analyze working capital to ensure that you are considering significant changes to customer or vendor terms in the calculation of the Peg.
 
Net working capital is an important component to any transaction. Gaining a comprehensive understanding of net working capital provides buyers the level of cash required to operate the business post transaction close, thereby avoiding unanticipated additional cash infusion. Developing a Peg that is mutually acceptable to the buyer and seller and including a clear definition of net working capital in the purchase and sale agreement will help avoid costly professional fees and management distractions resulting from a net working capital dispute litigation.