Navigating the Waters of Net Working Capital When Doing a Deal
When companies are sold, an often hotly-debated provision of the letter of intent and purchase and sale agreement is the seller’s net working capital (NWC) or sometimes referred to as the Net Working Capital peg. Because net working capital is most often a moving target, buyers can use and work around the lack of understanding of net working capital to benefit them to the detriment of the seller. This component of a deal can prove a real headache, but understanding the nuance of this double-edged sword is essential in getting a deal done on terms that make sense for a client.
What is Net Working Capital?
Net working capital is a good gauge of a company’s short-term ability to cover obligations. It’s typically a simple calculation derived from a company’s balance sheet wherein current liabilities are deducted from current assets. The change in net working capital from one period to the next is also typically used in the calculation of bottom-line cash flows.
In short, Net Working Capital = Current Assets – Current Liabilities. In doing deals, this is often pegged as TTM (trailing twelve month) on a per month calculation.
Sometimes buyers, in an attempt to simplify the process, will look at net working capital differently, depending on how they treat a transaction. For instance, I’ve seen buyers define net working capital as accounts receivable less any accounts payable. This tweaked way of looking at the calculation is atypical, but it is helpful to know how buyers may view this important calculation as sellers will need to know and be synced with proper nomenclature so everyone is on the same page.
Typical True-up
In many transactions, as a company valuation, the buyer will offer some multiple of gross profit, cash flow or EBITDA and tack-on a cash-for-cash purchase of the company’s net working capital directly from the balance sheet. Because net working capital is a moving target that changes depending on timing, how the net working capital appears during the IOI, LOI, due diligence and closing stages of a deal may be completely different. That is why most sellers and buyers simply agree to a 30, 60 or 90 day “true-up” of net working capital wherein the accounts receivable and accounts payable are presumably drawn down and the actual number is fleshed out.
In some instances, there are specific discussions and negotiations on the accounts receivable and its collect-ability. If a large number of receivables are beyond 90 and 120 days, the buyer may request they be removed from the calculation as a short-term asset and place the onus on the seller for collecting the overdue A/R. This is very common.
In the event that buyer and seller agree to a typical true-up, the benefit (or detriment) of what occurs between LOI and the actual close is typically a wash as the buyer will be paying dollar-for-dollar for any increase or decrease.
The Double-Edged Sword
In some instances, buyers will negotiate to retain net working capital for themselves. They argue the net working capital is needed to maintain on-going business operations without needing to infuse outside cash. This is very warranted, but it will be important to discuss potential pitfalls to this path and how to avoid the land mines.
In the negotiated instance of a moving net working capital number, there are a several scenarios that could transpire. Understanding, how net working capital is impacted and who benefits (buyer and seller) can help the parties to the transaction. If the buyer wishes to retain net working capital, there are two different scenarios that could play out.
Buyer Retains NWC + NWC Decreases Between LOI and Close
In the case of a deficit in net working capital, the buyer may simultaneously reduce the cash to the seller at close by the amount of the deficit. This is more common in companies that may experience seasonal or highly cyclical swings in collections. It could be based on annual seasons or the time of the month for payroll and other expenses. The levers can move quickly in companies that live and die by their line of credit.
Most buyers will wish to “have their cake and eat it to,” meaning they will wish to have all the potential upside in net working capital overfunding, but will want to have the seller take the fall on any deficit under a specific number. This is actually no far-fetched as some sellers may attempt withdraw cash or collect A/R out of the business prior to close, leaving the buyers with the bag to fund the on-going operations. While this scenario can be detrimental to the seller, it’s ultimately a built-in protection mechanism for the buyer.
Buyer Retains NWC + NWC Increases Between LOI and Close
Some buyers are savvy enough to include provisions in their LOI and purchase and sale agreement that handcuff the seller from withdrawing any cash from the business between the LOI and closing without express written consent from the buyer. Sometimes it’s even written egregiously enough to include payroll or other payables in the “without written consent” clause.
In most instances, this is good for the buyer but terribly bad for the seller. Cash will most likely accrue in the seller bank accounts (which cannot be withdrawn) and the buyer takes the windfall. Moreover, the seller will also benefit by more account accruals the longer s/he can drag out due diligence—which is one of many reasons I always advocate for a quick due diligence process.
I’ve seen this scenario play out in both directions. From the seller’s perspective, here are my preferences on how to negotiate net working capital (in order of decreasing preference):
- Have the buyer purchase the net working capital dollar-for-dollar with a 30, 60 or 90 day true-up. This is the cleanest method and doesn’t hold the NWC over a barrel which could cause the deal to get sidetracked. It also assumes the buyer pays for the business “as a going concern” and NWC is acquired as a separate asset. In my personal opinion, any other structure is disingenuous to the seller and typically can be manipulated by the buyer.
- Make both parties agree on a sufficient net working capital number. If there is deficit, seller must pay the deficit. If there is an increase, the benefit accrues to the seller. Be advised that buyers can almost always find more accounts payable and expenses that some sellers may have missed to winnow-down that NWC number to oblivion. If a controller is confident in NWC, then this can work, but it’s certainly not my favorite method.
- Allow the buyer to hold NWC hostage until the close of the deal, reaping all the accrued benefit in the process. For obvious reasons, this is not advised, but we’ve seen it in letters of intent and purchase agreements. It’s an easy provision to miss.
If a buyer is unwilling to purchase net working capital dollar-for-dollar, but wishes to include it as an asset in the transaction, the seller should understand this number will most likely change to his/her benefit or detriment depending on how the collection of A/R and A/P occurs near the close date. Understanding how the contracts are written (to the potential detriment on the sell-side), which structures will cause the greatest consternation and how to position oneself to reap the windfall by negotiating the right transaction with the right terms upfront is essential for not leaving money on the table.
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