Agreeing upon a figure for working capital is one of the trickiest parts of negotiating in certain business transactions. Not only are the numbers constantly changing, but this figure can also – and often is – the subject of many post-transaction disputes and litigation. It can be challenging to clearly define – and agree upon – all the specific working capital components that could 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 and find a way for both sides of the table to agree on how to arrive at that figure, 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) minus current liabilities (excluding debt and tax-related liabilities)
Although the formula appears to be somewhat 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.
An 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 a 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:
In addition to the importance of setting an NWC Target, it is crucial for the buyer and seller to understand the time 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:
The above accounts are among 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 and agree upon 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.
Do you have questions about working capital? Please contact SVA for more information.