Net Working Capital in M&A

Reaching an agreement on Net Working Capital (NWC) is one key aspect to the final negotiation of a company sale.

What is Working Capital? 

It 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.”

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. 

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.

Calculating Normalized NWC in M&A:

The standard calculation is:

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

Arriving at the agreed-upon framework for NWC calculation can be complicated and often heavily negotiated. Since it’s often a cash-free, debt-free deal, cash and debt are usually adjusted out of the NWC calculation. 

But wait, what is cash? And what is debt? These sound like silly questions but these definitions, especially debt, can be heavily negotiated. 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, customer escrows, etc., etc.?  Or what about debt? Does it include capital leases or certain accrued expenses? Or our favorite is when buyers try to put deferred revenue in as debt.

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 would this be done? Beyond the excluded cash and debt items, changes may be needed to normalize balance sheet items to a GAAP basis if the seller does not report as such (e.g., adjusting accounts receivable for any incorrect billings).

After the buyer and seller agree on the balance sheet items to be included, the appropriate historical period to analyze a normalized NWC must be determined. What is considered normalized is unique for every business but generally is based on historical trends. Typically, three, six, nine, or twelve-month historical averages are used 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 (i.e., rapid growth) just prior to the deal closing.

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.

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 – 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$500,000Negotiated amount of NWC to remain in business at close
Estimated NWC at Close$600,000Estimated at close by Seller
NWC Adjustment$100,000Added 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

Reaching an agreement on a business’s 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 would like to discuss this blog or learn more about our services.