Middle-Market M&A Insights: Q3 2023

For those well-versed in the business world, net working capital (NWC) is a familiar term. It is the difference between a company’s current assets – including cash, inventory, and accounts receivable – and its current liabilities – including short-term debts and accounts payable. But why is this seemingly mundane financial metric so crucial in the context of mergers and acquisitions (M&A)?

The Importance of Analyzing Net Working Capital

NWC is a measure of liquidity, and analyzing its historical trends can serve as a guideline for how much liquidity will be needed after the acquisition to maintain normal operations of the business without interruption or an immediate infusion of additional resources or capital from the buyer. Buyers receive NWC from the sellers at the close of the transaction as they “step into the shoes” of sellers.

The importance of negotiating an NWC amount (referred to as an NWC peg) is widely known in the M&A community. When a seller delivers NWC greater than the peg, they are compensated – dollar-for-dollar – for the excess. (The reverse is also true; when the seller delivers less NWC than the peg, the buyer is compensated for the deficiency.) This price adjustment mechanism, often called a true-up, serves as a balancing scale of sorts to help ensure that neither the buyer nor seller unfairly benefit or are unfairly penalized based on the actual NWC delivered to the buyer relative to the peg.

What sometimes gets overlooked is defining how to calculate NWC in the context of the deal. It is imperative to document how the peg was calculated and to ensure that the true-up mechanism is calculated in a consistent fashion. In virtually all cases we see, the NWC peg is calculated using a modified formula from the textbook definition. At its most basic level, this includes removing cash and any current debt (or debt-like balances) to reflect the cash-free, debt-free nature of transactions most prevalent in middle-market deals.

But is that all that is needed? What if the seller doesn’t use generally accepted accounting principles (GAAP) but the buyer does? Should NWC reflect the expectations of the buyer’s accounting policies or the seller’s historical practices? Left undefined in the purchase agreement, it is easy to see how a buyer and seller can have dramatically different expectations regarding the NWC to be delivered at close.

To help minimize the potential for disputes after closing, the NWC peg calculation, accounting methodology, and other details should be documented in the purchase agreement, with illustrative calculation schedules as deemed appropriate. As a final point of emphasis, note that the NWC peg formula does not have to be based on the seller’s historical practices nor does it have to be GAAP. This is a commercially negotiated aspect of the purchase agreement and can include (or exclude) virtually anything on which the buyer and seller agree. It is also imperative to closely define debt-like balances that will be excluded from NWC but also would impact the net purchase price.

Let’s review a simple example of what the gap might look like when a buyer is reporting the NWC delivered by the seller.

Facts: The NWC methodology in the purchase agreement isn’t clear. The buyer uses GAAP, and the seller uses a modified accrual basis of accounting, which includes regularly reconciling accounts receivable, accounts payable, and cash balances. The seller does not regularly analyze its inventory, assess the need for inventory reserves, or regularly reconcile other accrued expense accounts.

	Data	Buyer	Seller
Accounts Receivable	$1,200	$1,200	$1,200
Inventory	$2,000	$2,000	$2,000
Inventory Reserve	–	$(500)	–
Accounts Payable	$1,000	$(1,000)	$(1,000)
Accrued Expenses	$225	$(225)	$(75)
Accrued Wages	$40	$(40)	$(40)
Accrued Bonuses	$25	$(25)	$(25)
Net Working Capital		$1,410	$2,060
*All amounts in thousands

Disputes

Despite the parties’ best efforts, disputes can – and often do – arise when there is a significant difference between the peg and the final closing balance delivered to the buyer.

In the example above, the buyer calculated a closing NWC balance of $1.41 million, and the seller calculated a closing NWC balance of $2.06 million. That’s a $650,000 difference, which could be a material change to the purchase price in the context of this deal. The key differences in the above example relate to how the buyer calculated inventory and accrued expenses. The buyer believes that an inventory reserve of $500,000 should be applied to the net inventory balance relative to slow-moving and excess inventories. Further, the buyer calculated $225,000 for accrued expenses while the seller only calculated $75,000 for accrued expenses. The buyer included accrued expenses for accrued paid time off, sick pay, and commissions, whereas the seller was not aware of accruals for those items. The buyer’s calculation is likely GAAP-compliant, but the primary question is how the buyer and seller calculations relate to the language from the purchase agreement.

These disputes and negotiations can be messy, time-consuming, and costly since working capital adjustments also affect the net purchase price. It’s important to have an experienced advisor on your financial due diligence team who can help explain the calculations and help the parties navigate the complexities that are inherent in these conversations.

Conclusion

Because NWC influences the initial liquidity of the target company and the subsequent purchase price adjustment, it is important for parties to give due consideration to this aspect of the negotiation process and the language in the purchase agreement. We recommend two high-level steps to help ensure that both parties clearly understand what to expect:

1. Before the final purchase agreement language is agreed upon, buyers and sellers should consult with transaction advisory services professionals to ensure they understand the contractual provisions related to NWC and to potentially seek recommendations to clarify them.
2. Because they are usually the party responsible for preparing and submitting the initial price adjustment post-close, buyers should seek out the expertise of a transactions advisor to support the acquisition accounting required under ASC 805, the NWC true-up, and other factors affecting the purchase price adjustments as defined in the purchase agreement.

If you need help navigating net working capital or purchase price adjustments, our transaction advisory professionals are here to help. Contact your KSM advisor or complete this form.