A Guide to Navigating Net Working Capital in M&A Transactions

Mergers and acquisitions (M&A) often hinge on the careful evaluation and negotiation of net working capital (NWC). Disagreements between buyers and sellers on this front can lead to deals falling apart. Understanding and managing NWC effectively is crucial for a smooth transaction. This article delves into the intricacies of NWC in M&A, with a particular emphasis on strategies to avoid friction and ensure fair outcomes for both parties.

Understanding Net Working Capital
At its core, working capital is calculated using the formula: Working Capital = Current Assets – Current Liabilities. While this formula offers a snapshot of a company's financial health, it falls short of providing a comprehensive picture necessary for M&A transactions. For the typical cash-free/debt-free M&A deal, the formula must be refined to calculate "Net" Working Capital (NWC), which excludes items like cash, short term debt, and taxes owed, but includes operating items like receivables, payables, inventory, accrued expenses, and prepaid expenses.

The Challenge of NWC in M&A
Sellers naturally aim to minimize the amount of NWC they include in the deal while buyers want to acquire a company with ample assets to operate smoothly post-closing without infusing additional capital. This divergence often leads to disagreements.

Establishing the NWC Baseline
The first and most challenging step is to peg the historical NWC needs of the business. This involves calculating the NWC at multiple points over an extended period (e.g. 12-24 months) to determine an average. This trailing average typically forms the NWC baseline. Factors such as seasonality, large one-time sales, or projects must also be considered. It's crucial to agree on the baseline early in the sale process, ideally in the Letter of Intent (LOI).

Estimate NWC at Closing
Once the NWC baseline is established, the next step is to measure the actual NWC at the closing date. Since it's impractical to get exact figures on the closing day, an estimate based on the most recent month-end financials is used and is adjusted for major inflows and outflows expected up to the closing date. If the NWC baseline is less than the NWC estimate, the seller receives a surplus payout at closing. Conversely, if the NWC baseline is greater than the NWC estimate, the seller must leave part of their proceeds in escrow to cover the shortfall.

True-up NWC Post-Closing
The final step involves a "true up" post-closing, once the final NWC figures are available. This step reconciles any discrepancies between the NWC estimate and the actual NWC at closing. If the seller received too much at closing, they must refund the excess to the buyer. If they received too little, the buyer must compensate the seller for the shortfall. Typically, a portion of the sale proceeds is held in escrow to cover these adjustments.

The Importance of Accurate Working Capital Adjustments
Working capital adjustments are critical in M&A transactions to ensure that the acquired company has sufficient liquidity to continue operations without additional capital infusion from the buyer. These adjustments can affect the purchase price, making it essential for both parties to agree on a working capital target early in the transaction process. This target or baseline may be revisited and finalized during the due diligence phase, and any discrepancies are settled post-closing.

Key Considerations for Sellers
Sellers should have a clear understanding of how their NWC estimates are calculated and ensure that all current assets are included. Awareness of potential buyer tactics to justify downward adjustments is also crucial.

Sellers should also seriously consider viable strategies to reduce their working capital needs well in advance of a planned sale.  Carrying excess inventory or allowing receivables to go on uncollected too long can impact your ability negotiate a fair baseline.

Conclusion
Effective management of NWC in M&A transactions is vital for ensuring a fair and successful deal. By adhering to this approach, both buyers and sellers can navigate the complexities of working capital adjustments and minimize friction. For cash-free/debt-free deals, once the baseline is agreed upon, sellers are in the best position to manage the business post-LOI without impacting the deal. For example, if it is the right time to purchase inventory, then the NWC will be offset by an equivalent amount of cash or trade payables.  When receivables are collected the decrease in NWC is offset by the increased cash retained at close. When trade payables are paid with cash, the reduction in cash is offset by the reduction of the trade payable liability in the NWC.
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Accurate and early agreement on NWC calculations, coupled with thorough due diligence, can pave the way for a smooth transition and a mutually beneficial transaction.

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