Bill Kenedy, Lutz Consulting
We have found that net working capital (“NWC”) targets are one of the most commonly misunderstood components of M&A deals. While sometimes confusing, we believe sellers need to understand the logic behind NWC targets, as it can often become one of the more heavily negotiated items in M&A deals. If sellers have a better grasp of the what, how, and why of NWC targets, we believe it should make for a smoother negotiation to help get a deal to closing.
WHAT IS NET WORKING CAPITAL?
In nearly every transaction, a buyer will require a selling company to leave behind a defined minimum amount of working capital. A company uses working capital (current assets minus current liabilities) to fund its ongoing operations. In the context of M&A, buyers will view sufficient NWC, essentially, the same as other assets purchased in the deal.
From a buyer’s perspective, current assets such as accounts receivable (A/R), inventory, and prepaid expenses are all necessary to maintain ongoing operations. This minimum level of NWC is assumed as part of the valuation process, and from a buyer’s perspective, is included in the price (multiple) offered for acquiring the business. Therefore, a seller could expect a purchase price reduction if actual NWC closing to is less than what was negotiated. Buyers and sellers tend to spend considerable time and effort negotiating what this amount should be.
For M&A deals, the NWC definition and target are both included in the deal purchase agreement and many times outlined in the Letter of Intent (LOI) stage of the process. It’s important to note that NWC in a deal can differ from the textbook definition of current assets minus current liabilities. This difference is because a buyer will only acquire those NWC items that are critical to running operations going forward, nothing more or less. Typically, related party items, short-term debt and lines of credit, and taxes receivable/payable are not included. NWC targets are typically set on a ‘cash free, debt free’ basis. This means the seller keeps the cash in the business but is responsible for paying off any bank debts.
The NWC analysis typically is part of the buyer’s due diligence and involves a detailed analysis of balances at the account level. It could be that some item under accrued expense or accounts payable may not be truly operational in nature and would be excluded from NWC. By the same token, if a buyer determines that something has been improperly omitted from a balance sheet line item, they may adjust historical balances to reflect these accounting errors. All of this is done in order to accurately determine what a true “normalized” level of NWC should be given the company’s historical revenue and EBITDA.
HOW ARE NWC TARGETS DETERMINED FOR M&A DEALS?
In most cases, buyers will calculate a historical average (typically 12 months) in order to set an appropriate target that would need to be delivered at closing. The rationale is that a buyer is basing its valuation off of revenue and EBITDA, and the working capital needed to generate that revenue and EBITDA will need to be provided (same as with other business assets). A seller needs to be cognizant that its EBITDA will usually reflect A/R as revenue and A/P as an expense, yet they remain uncollected or unpaid at closing. Since the valuation is usually based off of EBITDA, all items that went into EBITDA need to be accounted for. So, in setting these targets, a buyer will often assume a 12-month average to be a “normalized” level. A 12-month period is used in order to average out fluctuations, and because valuations are typically based off of trailing 12-month EBITDA. If a seller delivers NWC that exceeds the target, they will be paid dollar-for-dollar for that excess. If a seller delivers less NWC, the buyer typically will reduce the purchase price dollar-for-dollar to offset the deficit. Sellers should be aware of this basic approach to NWC targets, as this arises in nearly every middle-market M&A transaction.
WHY ARE NWC TARGETS USED IN M&A TRANSACTIONS?
Sellers often mistakenly assume they can retain (“keep”) A/R post-close and/or aggressively collect and reduce A/R in order to keep more cash at closing. Since sellers keep the cash in most deals, this logic seems to make sense on the surface. However, a buyer would not be willing to pay full price if it based its valuation on EBITDA that was not supported with sufficient NWC (i.e., low A/R).
If there is low A/R or Inventory at close, the buyer would need to fund those items in order to operate the business, which is effectively asking for more purchase price. By the same token, if A/R was abnormally high or if A/P was paid down and now was below normal levels, a seller could expect the buyer to increase purchase price to account for the higher NWC. These fluctuations in NWC are why targets are established (see previous paragraph).
A seller needs to be aware that, net-net, these targets and potential variances typically do not have an economic impact to them. If NWC was higher than an established target, the seller would deliver more NWC but they would be paid dollar-for-dollar for this excess. If a seller thought that collecting A/R and pocketing the cash was clever, they should know that a buyer will discount its purchase by any potential deficit. However, even if NWC came in below a target and purchase price was adjusted lower, a seller will be able to keep the cash that was collected, so any impact is essentially non-existent. The purpose of NWC targets is to protect both parties from any gamesmanship on NWC levels given the agreed-upon valuation.
Given the above considerations, you may wonder why any of this is of concern. We believe sellers should be aware that they likely will not be able to “game” NWC levels to their advantage given the trigger mechanism of NWC targets. If nothing else, this should prepare sellers for what to expect. But, more importantly, sellers should be aware that negotiating the actual target level is what is critically important. If a target is set too high, then a seller could be forfeiting closing payments that would otherwise be coming to them. This issue of where to set these targets can often become heavily negotiated in M&A deals, particularly when a buyer is asking for adjustments to historical balances given its due diligence findings. Another area of negotiation may revolve around some balance sheet item that may be artificially high or low, and how this might impact the target calculation. With the help of an experienced and knowledgeable M&A advisor, the seller can navigate these waters and be comfortable that these NWC targets are set at appropriate levels.
ABOUT THE AUTHOR
Bill Kenedy is a Lutz Consulting and M&A Shareholder at Lutz. He specializes in business valuation, litigation support, and merger and acquisition advisory services. 402.492.2132 bkenedy@lutz.us
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