Net Working Capital in an M&A Transaction

Net Working Capital in an M&A Transaction

by Joe Hellman, CPA

An M&A transaction is complex. The purchase price is often thought about as the enterprise value (adjusted EBITDA times a multiple). Something that is often forgotten until the end is net working capital.

Assessing net working capital is a crucial component of financial due diligence, along with a quality of earnings report, and analysis of debt and debt-like items. The net working capital number reflects the company’s overall financial health, in particular its liquidity.

As a simple calculation, net working capital is the difference between current assets and current liabilities. The net number can be positive or negative. It sounds easy, then, to arrive at an established number or peg everyone can agree on, but it is not. Nonetheless, developing an accurate, agreed-upon figure provides comfort to both the buyer and seller that there will not be a significant change in the purchase price at close.

Net Working Capital Also Affects Post-Acquisition Performance

One of the most critical issues – at least from the buyer’s point of view – is that the new company have adequate working capital available starting Day 1 and carrying through at least for the short term.

Commonly, private M&A transactions aim for the company to be debt-free, cash-free at close. The owner pays off any current debts and retains any remaining cash. 

If, for some reason, the business has higher than its established target or peg for net working capital at close, a surplus would result in an increase to the purchase price. On the other hand, if net working capital at close is lower than the established target or peg, a shortfall would result in a decrease to the purchase price. This is a very simplified example of how net working capital comes into play. The use of collars and caps to establish a range is not uncommon and can impact the purchase price as well.

The net working capital established target or peg can be calculated in a variety of ways and there is often not a right or wrong way in doing so. The key to ensuring there are no post-close disputes is to have the purchase agreement wording aligned with exhibits used during the negotiations between the buyers and the sellers. Having the methodology applied consistently for establishing a target or peg, and when calculating the true-up post-close, will be instrumental in avoiding disputes.

Finding the Right Number

There is no simple or universal formula for calculating net working capital, so this issue can easily become contentious. Many companies do not fully comply with Generally Accepted Accounting Practices (GAAP) and saying that your financial statements and net working capital number is in compliance with GAAP is not enough and may actually harm you as you go through negotiations. There are multiple considerations and multiple potential adjustments that may be made before arriving at a final figure both parties can agree on.

Without both-party agreement -- in definition and in number -- to what constitutes indebtedness and net working capital, the deal could fail. 

Buyer or seller, you want the M&A process to move forward as smoothly and as advantageously as possible. The sheer complexity of calculating net working capital – and the potential downside to getting it wrong – underscore the importance of including your M&A advisory team from the beginning. Their expertise and guidance in this and all aspects of financial due diligence can protect your company and help you negotiate the best possible deal.

 

New call-to-action

Joe Hellman, CPA

Joe Hellman, CPA

Joe Hellman is a partner leading the Transaction Advisory Services practice at Redpath and Company. He provides support to clients throughout the transaction life cycle, from evaluating opportunities pre-LOI to post-close net working capital true-ups and synergy assessments on both buy-side and sell-side transactions. Joe has experience across a variety of industries including manufacturing, healthcare, construction, consumer products, distribution, financial services, and energy. He has provided public accounting services since 2008 and joined Redpath and Company in 2020.