What Is Net Working Capital (NWC) in M&A?

June 9, 2022

NWCheader

Reaching an agreement on Net Working Capital (NWC) is one key aspect of the final negotiation of a company sale. NWC looks at the money you have available to meet your current obligations and can serve as an indicator of your business’ liquidity in the short-term while offering insights into its operational efficiency.

NWC is important for M&A because it impacts purchase price if the amount agreed upon between buyer and seller isn’t the same as the actual amount. This is important to calculate correctly so the purchase price isn’t being changed overall. But there are so many nuances when it comes to determining what to include or not include when determining NWC calculations. Let’s take a look at some specifics, and learn how an advisor can help you navigate the process.

What is Net Working Capital?

NWC is the current assets minus the current liabilities of a business. In software M&A, it is common for acquisitions to be completed on a “cash-free and debt-free” basis. This means that the selling shareholders keep the cash on the balance sheet at the transaction close while paying off all interest-bearing debt. So for purposes of M&A, the baseline NWC calculation is often current assets (less cash), minus the current liabilities (less debt).

definition of net working capital

Calculating Normalized NWC in M&A

NWC is important for M&A because it highlights whether or not you have enough to cover your business’ debts – and can influence how easily the M&A transaction is able to take place (if at all).

The standard calculation to find NWC is:

Net Working Capital (NWC) = Current Assets (less cash) – Current Liabilities (less debt)

Arriving at the agreed-upon framework for NWC calculation can be complicated and the process is often heavily negotiated.

negotiable items in net working capital

Cash & Debt

Since it’s often a cash-free, debt-free deal, cash and debt are usually adjusted out of the NWC calculation.

But what is cash? And what is debt? These sound like silly questions but these definitions, especially debt, can be heavily negotiated and affect the way you calculate NWC. (And remember, anything that is debt is a dollar-for-dollar purchase price reduction, so it is critical.) Does cash include all cash, restricted cash, and customer escrows? Or what about debt? Does it include capital leases or certain accrued expenses? (Our favorite is when buyers try to put deferred revenue in as debt.)

Current Assets & Current Liabilities

Once cash and debt are agreed upon, the buyer and seller must determine if any current asset and current liability items should be adjusted. Why do we do this? Beyond the excluded cash and debt items, a business might need to make some changes to normalize balance sheet items to a GAAP basis if the seller does not report as such (like adjusting accounts receivable for any incorrect billings).

Normalized NWC

After the buyer and seller agree on the balance sheet items to be included, they determine the appropriate historical period to analyze a normalized NWC. What is considered normalized is unique for every business but generally is based on historical trends. Typically, SaaS businesses use three-, six-, nine-, or 12-month historical averages to analyze historical needs.

If a business is affected by seasonality, a longer period could be the best indicator of the amount needed for working capital to even it out, or you might adjust for the distortions from seasonal trends. Alternatively, a shorter period may be appropriate if the business trajectory has changed dramatically (for example, rapid growth) just prior to the deal closing.

Target NWC

Buyers and sellers will leverage the insights from historical trends, with any necessary adjustments, to negotiate a target NWC. The target NWC is the amount of working capital the business is expected to have at the time of close.

Next, the seller will prepare a forecasted balance sheet as of the expected close date of the transaction. This forecast will contain the estimated NWC at the close date, which will be compared against the target NWC. Any surplus/deficit between the target NWC and the estimated NWC may result in a dollar-for-dollar increase/decrease to the purchase price at the close.

Collar

In some transactions, the buyer and seller may include a “collar” as part of working capital to avoid minor adjustments for slight differences between the target NWC and estimated NWC. If the difference between the target NWC and estimated NWC is within the negotiated collar amount, then no adjustment is made. There are also different collar types negotiated to handle cases where the difference is larger than the collar. One method is to adjust the purchase price by the entire difference. Another method is to adjust the purchase price by only the amount exceeding the collar.

Post deal close, there is a “true-up period,” which typically lasts 60 to 90 days, during which time the actual NWC as of the close date is calculated with the monthly books finalized. Any difference between the actual NWC and estimated NWC at the close is compensated for via the NWC escrow, a small amount of cash held back from the purchase price at close to settle any final minor adjustments. Whatever is left is distributed to the selling shareholders at the end of the true-up period.

Summary Example of NWC

Negotiated NWC Target $500,000 Negotiated amount of NWC to remain in business at close
Estimated NWC at Close $600,000 Estimated at close by Seller
NWC Adjustment $100,000 Added to initial purchase price at closing
Actual NWC at Close (at true-up) $590,000 $10K paid out from seller’s NWC escrow to buyer since Actual NWC was $10K lower than Estimated NWC

Why is NWC important in M&A?

Offers to acquire a business are often done assuming a “normalized level of working capital” remains in the business. What does this mean? Working capital is used to fund the daily operations of the business. Buyers want to ensure sufficient working capital is left in the business to avoid writing a check to acquire the business and then immediately writing another check to fund payroll or some other cash liability.

To put it simply, a positive NWC means you have enough to cover your business’ current financial obligations. Negative NWC means you don’t. Net zero NWC means you have exactly enough liquid capital to cover your debts, but no extra cash flow.

importance of net working capital in m&a

Like many things in M&A, at the surface level, it would appear to be a straightforward calculation to determine how much working capital should be left in the business. However, there are often many nuances to be considered to ensure a fair result for both the buyer and seller. And getting it right is critical since differences between the agreed-upon amount of working capital to be left in the business, and the actual amount left in the business is often a dollar-for-dollar purchase price adjustment.

What is NWC Ratio?

The net working capital ratio measures the percent of a SaaS company’s current assets against its current debts to determine its ability to pay off its current liabilities with what it has liquid.

NWC Ratio = Current Assets ÷ Current Liabilities

This ratio gives companies an idea of their business’s liquidity, and helps them determine their overall financial health. The ideal ratio is 2: to have twice as much in assets as debts.

Reaching an agreement on a business’ Net Working Capital is critical to ensure a fair result for both the buyer and seller. As there are many nuances to be considered, working with an advisor to manage this key negotiation can help minimize changes in the final purchase price and create a smoother process overall.

For over 30 years, Software Equity group has provided unparalleled software M&A advisory services for emerging and established software companies. Don’t hesitate to reach out if you are preparing to sell your business and would like to learn more about the factors that matter most to improving the value of your company.

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