Net working capital (“NWC”) is a crucial financial component of middle-market M&A transactions. Understanding the impacts NWC has on an M&A transaction is important and can alleviate last-minute surprises, confusion, and potential legal disputes.
What is Net Working Capital?
In financial reporting, NWC is defined as a company’s current assets minus current liabilities, as reported on the balance sheet. Current assets include cash and other short-term assets, such as inventory and accounts receivable, that are expected to convert to cash within a normal operating cycle (typically one year or less). Current liabilities include short-term obligations, such as accounts payable and accrued expenses, that are due to be paid within the one-year operating cycle.
NWC measures a company’s operational liquidity, its ability to meet short-term obligations, and its financial health at a point in time. NWC can be either positive or negative. A positive NWC (i.e., when current assets exceed current liabilities) indicates that a company has enough funds to cover short-term liabilities, maintain operations, and invest in future growth. However, an unusually high NWC may signal inefficiency, such as excess inventory or unproductive cash reserves.
On the other hand, a negative NWC (i.e., when current liabilities exceed current assets) may suggest challenges in meeting obligations and could limit growth opportunities. However, negative NWC isn’t always a sign of financial trouble—certain business models, such as retail or Software-as-a-Service (SaaS) companies, often operate with faster cash inflows than outflows, making negative NWC sustainable.
Regardless of whether NWC is positive or negative, business owners should be prepared to explain and justify the NWC requirements of their company. In any case, NWC is a vital metric for assessing a company’s operations and varies based on the nature of the business.
NWC’s Role in an M&A Transaction
In an M&A transaction, NWC is typically included in the sale and factored into the agreed-upon purchase price. At closing, NWC is transferred from the seller to the buyer. The buyer will require the seller to leave behind a specified amount of NWC to ensure that the buyer is not burdened after the transaction. This ensures the buyer has sufficient NWC from day one to generate cash flow and maintain normal operations without needing additional capital. An easy analogy is buying a car: in this case, the company is the car, and the NWC is the full tank of gas. Just as a buyer expects a car to have a full tank when driving off the lot, the buyer of a company expects to have enough NWC to operate smoothly post-acquisition.
In an M&A transaction, there are three key definitions of NWC that affect the purchase price: 1) NWC Target (also called “NWC Peg”), 2) Estimated NWC and 3) Actual NWC. The NWC Target is agreed upon by both parties before closing and represents the amount of NWC the seller is expected to deliver to the buyer at closing.
The Estimated NWC is an estimation of the NWC calculated right before closing. Since it is impractical to have an exact balance sheet on the closing date due to timing constraints in accounting and financial reporting, the seller provides an estimate of the NWC at that time. Post-closing, there is typically a period of 30 to 120 days during which the Estimated NWC is adjusted to reflect the Actual NWC once the final information is available.
The difference between the Actual NWC and the NWC Target is known as the NWC Adjustment. This adjustment typically impacts the purchase price dollar-for-dollar. If the NWC delivered is higher than the NWC Target, the buyer pays the seller the difference, increasing the purchase price. Conversely, if the NWC delivered is lower than the NWC Target, the seller pays the buyer the difference, reducing the purchase price.
The NWC adjustment is calculated at two key points during a transaction: at closing and post-closing. At closing, the NWC Adjustment is initially calculated by comparing the Estimated NWC to the NWC Target, and this difference is factored into the purchase price on the closing date. After closing, the Actual NWC is compared to the NWC Target, and the resulting difference is included as a final purchase price adjustment, net of the adjustment made at closing.
The purpose of the NWC Target is to provide the most accurate estimate possible. Neither the buyer nor the seller is intended to benefit disproportionately from the NWC Adjustment. This is why the NWC Target is crucial: dedicating time and effort to calculating an accurate NWC Target helps minimize the risk of disputes or unexpected purchase price adjustments after closing.
Final Thoughts
Establishing and defining the NWC Target can be highly negotiated due to the numerous variables involved. When done correctly, the NWC Target should not significantly affect the overall purchase price. Given the complexities of NWC, middle-market business owners considering a sale should understand its potential impact and consider working with experienced advisors, including QOE providers, who have extensive M&A expertise.
Stay tuned for Part II of this article where we will explore how to calculate a NWC Target and the impact of financial due diligence on NWC Targets.
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This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.
