Net Working Capital (NWC) for M&A – A Complete Guide

by Jacob Orosz (President of Morgan & Westfield)

Executive Summary

Who Should Read This Article

If your business requires a significant amount of working capital to operate, then you must understand net working capital before you sell. NWC may constitute a significant percent of the purchase price, and any mistakes you make in the calculation or when negotiating terms will have a material impact on your net proceeds. For some sellers, this can amount to 20% or more of the purchase price.

Definitions

Working Capital: A common accounting term, working capital is the difference between a company’s current assets and current liabilities, where current refers to a period of one year or less. In other words, working capital is a measure of a company’s operating liquidity – or its ability to fund operations and meet its short-term obligations.

Working Capital = Current Assets minus Current Liabilities.

Net Working Capital: More common in M&A, net working capital (NWC) is equal to working capital, less any cash and debt in the business. It’s sometimes called “non-cash working capital.” Most M&A transactions include working capital in the purchase price, but buyers don’t necessarily require all the current assets to run the business, such as excess cash in the bank account. And they don’t always assume all the current liabilities, such as lines of credit. Hence the different definition.

Net Working Capital = Current Assets (excluding cash) minus Current Liabilities (excluding debt).

In most M&A transactions, the target company is acquired on a cash-free, debt-free basis. This means the seller keeps the cash in the business and must pay off any debt upon closing. In a typical transaction, the purchase price doesn’t include cash, and the buyer doesn’t assume any debt.

Here’s a breakdown of the primary components of net working capital:

Current Assets
Included in net working capital	Excluded from net working capital
Accounts receivableInventory of finished goods, raw materials, or work-in-progressPetty cash (e.g., cash in registers required to operate a retail business)Prepaid expenses	Cash and cash equivalentsMarketable securities

Current Liabilities
Included in net working capital	Excluded from net working capital
Accounts payable (e.g., supplier and vendor expenses)Accrued but unpaid expenses (e.g., payroll)Customer depositsDeferred revenue	Related-party itemsShort-term debtLines of creditTaxes payable

Introduction

Did you know that having a firm grip on net working capital, how it’s calculated and negotiated as part of the process of selling your business, can potentially save you millions of dollars? Not only that, but nasty surprises often come in the form of a purchase price adjustment three months after the closing. Yes, you read that right. As the seller, you may not know the actual purchase price until after the deal is done. In an episode of our M&A Talk podcast, my guest was involved in litigation around a $4m claim regarding working capital, and it’s clear the risks are easy to miss. If you want to avoid a million-dollar whammy and not leave millions on the table when selling, read on.

What is working capital?

Working capital is a commonly used financial metric that represents the difference between a company’s current assets and its current liabilities. It’s not, as many business owners assume, the amount of cash they must maintain in their bank accounts to operate. Calculating net working capital is slightly more complex and requires a separate definition.

What is NET working capital?

Net working capital, or NWC for short, offers a clearer picture or a more accurate estimate of a business’s ongoing operating expenses that buyers use to evaluate an acquisition. Properly calculating NWC is vital in M&A transactions because the acquirer must make sure the target business has a sufficient amount of working capital to continue to operate after closing. An insufficient amount would require the buyer to inject additional cash into the business, which increases the effective purchase price and reduces their return on investment. To prevent this, the purchase price in nearly all middle-market acquisitions includes a set amount of working capital, known as a net working capital target, or peg for short.

NWC targets are a frequently misunderstood concept in M&A and a common reason for post-closing disputes and litigation. Developing a working capital target that’s acceptable to both parties and clearly defining NWC in the purchase agreement are crucial steps in avoiding this.

How NWC Fits Into the M&A Process

The following describes how working capital is negotiated in a typical M&A transaction:

• Stage #1 – Letter of Intent: The parties agree on whether working capital will be included in the transaction. If so, they set a working capital target, or peg, to be included in the purchase price.
• Stage #2 – Due Diligence: The buyer performs financial due diligence to determine a more precise working capital target. This involves an analysis of balances (for both current assets and current liabilities) over a specific time period, such as the previous three, six, or 12 months. The time period can sometimes be a matter of intense negotiations because of its impact on the price, especially for seasonal businesses.
• Stage #3 – Purchase Agreement: The purchase agreement defines exactly what’s included in working capital and how it will be calculated. For clarity, a sample calculation should be included in the agreement.
• Stage #4 – Closing: Working capital is estimated at closing. It can’t be set in stone at this point because the final account balances won’t be available until three to four months after closing.
• Stage #5 – Post-Closing Settlement (Adjustment): Working capital is reconciled, or “trued up,” 60 to 120 days after the closing. At this point, all accounts are closed and can be finalized – such as all accounts receivable have been collected and can be calculated. This allows the buyer to receive a more accurate working capital total. The amount is compared with the target (peg), and any difference is reconciled between the parties. If NWC comes in above target, the buyer pays the seller the difference. If it is below the target, the seller pays the buyer the difference. Agreeing on a peg prevents the seller from eroding working capital for their own benefit. For example, the seller could liquidate inventory before closing to increase their cash proceeds or speed up accounts collection to put more cash in their pocket.

Negotiating the NWC Target

There are two major elements to negotiating NWC:

• The Target: Naturally, both parties have opposing interests when negotiating the target. The buyer prefers a higher target, while the seller prefers the lowest possible. The common ground is to agree on a target that can sustain normal operations so the buyer will not need to inject additional cash or increase borrowing to operate the business post-close.
• The Formula: This involves negotiating the formula for calculating the actual working capital for the target. This formula must be consistent for use at closing and at the true-up period (60 to 120 days post-close).

FAQs on NWC

Why is NWC included in the purchase price?

Working capital is necessary to maintain the ongoing operations of a business, so most sophisticated buyers include it in the purchase price when they submit an offer. This ensures they have enough working capital to operate the business post-closure and won’t need to inject extra money. NWC gives a buyer a clear idea of the level of capital required to keep the business running.

Why a target?

Working capital fluctuates for most businesses and is subject to manipulation. Agreeing on a target reduces friction between the parties by reducing the seller’s ability to manipulate it. The buyer and seller can agree on how much working capital to include in the purchase price without worrying about whether the actual amount will vary between signing the letter of intent (LOI) and closing.

How does the target protect the parties?

A working capital target protects the buyer by reducing the purchase price if the amount of working capital is less at closing than the parties agreed to. Purchase price adjustments can also go in the seller’s favor if they deliver working capital above the target.

Is calculating NWC subjective?

Calculating a working capital target is both an art and a science. The art lies in identifying normalizing, non-operating, and non-recurring items in working capital and determining to what extent these should be included or excluded in the calculation. Fortunately for the buyer, these are often identified during financial due diligence, giving them leverage to propose a target heavily weighted in their favor. What remains is a science: calculations are carefully identified and defined in the purchase agreement.

How NWC is Calculated

The working capital calculation should be based on a specific timeframe. Setting that timeframe depends on a couple of common methods of calculation.

• Historical Average: In most cases, buyers calculate a historical average, typically based on accounts from the previous 12 months.
• Percentage of Revenue: Alternatively, working capital can be derived as a percentage of revenue. For example, the working capital accounts can be calculated at the end of each month over the previous six months and compared with either revenue or costs of goods sold each month. Then, a percentage of revenue or costs of goods sold can be used as a baseline for setting the target.

Choosing the Right Period

The average period could be shorter – three or six months – if it better reflects the operations of the business or the near-future outlook. Rapid growth requires an additional infusion of working capital, so a calculation based on a historical timeframe would not be sufficient to support revenue in the months immediately following the closing. Best practice is to use a longer timeframe to smooth out any abnormalities, such as the impact of seasonality, rapid growth, or a decline in the business, all of which can affect the calculation.

Example NWC Calculation #1

The following is a sample calculation for a seasonal business with a busy period from May to August. Amounts are in millions, and the final column shows the last twelve months’ (LTM) average.

In this case, the average NWC is $4.3 million, which would be delivered to the buyer at closing.

Example Calculation #2: NWC at Close vs. the Target

Scenario #1 – NWC higher than the target

• Net Working Capital at Close: $12,000,000
• Net Working Capital Target: $10,000,000
• Excess NWC: $2,000,000 Adjustment: The buyer will pay an additional $2,000,000, via a purchase price adjustment, because the seller delivered working capital at close that was higher than the target.

Scenario #2 – NWC lower than the target

• Net Working Capital at Close: $22,000,000
• Net Working Capital Target: $26,000,000
• Deficit NWC: $4,000,000
• Adjustment: The seller will receive $4,000,000 less, via a purchase price adjustment, because they delivered less working capital at close than the target.

The Working Capital Cycle

When examining working capital, it’s helpful to know the working capital cycle, or the time it takes to convert working capital into cash. Companies that turn over inventory fast and immediately receive payment from customers – such as most retailers and B2C companies – can operate with minimal or even negative working capital. Businesses like these are often more scalable, unless they are “asset-intensive” and require a significant investment in long-term assets, such as airlines or manufacturing companies.

Tips for Sellers

• Define Working Capital: Include a comprehensive definition of working capital in the purchase agreement to reduce any disagreements or possible litigation.
• Get a QoE Analysis: Before you begin the sales process, it’s best to hire a quality of earnings (QoE) firm to perform an analysis, which should include an assessment of working capital.
• Understand Your Working Capital Needs: You can use the information from the QoE analysis to establish a defensive working capital calculation, which will minimize potential purchase price erosion. This calculation has a dollar-for-dollar impact on purchase price, and performing the analysis in advance can boost the final amount. It can also reduce disputes later in the transaction, during due diligence or purchase price negotiations. The QoE analysis will also help you understand each of the accounts that comprise working capital, which can help you reduce the amount required to operate. So, in effect, you can increase your cash proceeds at closing.
• Start Preparations Early: Buyers are cautious and on the lookout for significant changes to working capital in the short term. Any improvements should be made well before the sales process begins. They should be feasible and, ideally, sustained over more than four quarters.
• Reduce Net Working Capital: Businesses can optimize cash flow, improve short-term liquidity, and reduce working capital in the following ways:
  • Reduce the amount of inventory:
    • Increase the inventory turnover ratio – i.e., cost of goods divided by average inventory
    • Improve the inventory-to-sales ratio – i.e., net sales divided by average inventory
    • Increasing the inventory sell-through rate
  • Reduce the amount of accounts receivable:
    • Increase the accounts receivable turnover ratio – i.e., net credit sales divided by average accounts receivable – by aggressively collecting receivables
    • Decrease sales outstanding receivables – i.e., average accounts receivable balance divided by total revenue multiplied by days in the period – by aggressively collecting receivables
  • Increase accounts payable:
    • Decrease the average accounts payable turnover ratio by slowing down payments to suppliers

Tips to Reduce Working Capital

If a seller tightens the working capital cycle several quarters before the sale, they demonstrate to buyers that the change is sustainable. The longer this new norm is maintained, the more likely the buyer will accept it. As a seller, every dollar you reduce the working capital before closing effectively goes into your pocket at the closing table.

To tighten the working capital cycle, you can do the following:

• Speed up collection of accounts receivable
• Extend supplier credit terms to market norms
• Increase inventory turns (the time between buying and selling items)
• Reduce the overall operating or process cycle times

Businesses that require less working capital are often more scalable than those that require more.

Definition: Working Capital vs. Net Working Capital

The Textbook Definition of Working Capital

The technical, or textbook, definition of working capital is the difference, on the balance sheet, between a company’s current assets and its current liabilities.

The Layman’s, or Real World, Definition of Working Capital

Working capital is a measure of a company’s operating liquidity – its ability to meet short-term obligations and fund operations. Many business owners colloquially refer to working capital as the money they hold in the business’s checking account, or the funds required to operate. But a more precise definition is needed when it comes to selling your company.

Why is a different definition needed?

Most M&A transactions include working capital in the purchase price. But acquirers don’t necessarily need all the components of current assets and don’t always assume all the seller’s current liabilities. So, a different definition is needed.

In most M&A transactions, the target is acquired on a cash-free, debt-free basis. This means the seller keeps the cash but is responsible for paying off any debt at closing. In other words, the purchase price doesn’t include cash or the money in checking and savings accounts, and the buyer doesn’t assume any debt. Hence, we have non-cash net working capital – or net working capital (NWC) for short.

The M&A Definition of Net Working Capital

Net Working Capital = Current Assets, excluding cash, minus Current Liabilities, excluding debt.

On the surface, the definition of working capital appears objective and straightforward. But in M&A, the definition of working capital is subjective, usually defined between the parties and subject to manipulation, which commonly results in disputes.

Following is a list of which assets and liabilities are typically included or excluded from the definition of net working capital:

The M&A Process

In any acquisition, a buyer will want to know how much working capital is required to sustain current operations. Estimating how much working capital is required helps the buyer avoid any unanticipated cash infusions after closing.

The following describes when and how working capital is negotiated as part of a typical M&A transaction:

Stage #1 – Letter of Intent

Objective: The parties agree on whether working capital will be included in the transaction. If so, they will ideally agree on a definition of working capital and how to calculate it.

The NWC target should be addressed at the beginning stage of negotiations. Agreeing to define it later in the process nearly always works out in the buyer’s favor. The letter of intent (LOI) should outline how working capital will be calculated, what constitutes a “normal” level of working capital, and address any special circumstances, such as discounts applied to aged receivables or outdated inventory.

The challenge at this stage is that financial due diligence has not been completed, and buyers are unlikely to set an accurate working capital target in the LOI. The solution is for sellers to retain a quality of earnings firm to prepare a report before going to market, which will include a net working capital analysis.

If the seller has paid for a sell-side QoE analysis, we normally see language like this in LOIs:

“The working capital target will be determined using a mutually acceptable methodology which will be determined during financial due diligence.”

Ideally, the LOI will outline how working capital will be defined in the purchase and sale agreement and include an estimate of working capital (i.e., the peg). In some cases, the amount, such as the net working capital peg, is not included in the LOI, which commonly leads to disagreements later in the negotiations. The LOI can state an acceptable methodology to calculate a peg in lieu of an actual target, which may be further defined during financial due diligence.

A typical NWC clause in an LOI reads:

“The purchase price includes an assumed normalized level of net working capital (typically referred to as a Net Working Capital Target [“target”]) at closing.”
or….
“The purchase price includes working capital, which is defined as (i) current assets (excluding cash); (ii) less current liabilities (excluding debt); (iii) less items that are excluded by definition in the purchase agreement; or (iv) plus or minus pro forma or due diligence adjustments determined during the financial due diligence analysis (such as the need for a bad-debt allowance).”

Ideally, the buyer and seller will either negotiate a specific definition of working capital or negotiate the actual target in the LOI (i.e., a specific dollar amount). The target is one of the most commonly negotiated terms because the variables can have significant implications after the deal is closed.
The LOI should state an acceptable methodology to calculate an NWC target, which may be further defined during financial due diligence.

Stage #2 – Due Diligence

Objective: Set a working capital target.

One of the main areas of financial due diligence is an NWC analysis, which is often included in a quality of earnings (QoE) analysis. To determine a normal level of NWC, due diligence can use an average of the previous six to 12 months, commonly referred to as the target, or peg. In most cases, the working capital target will be an average of the trailing twelve months (TTM).

The NWC analysis is typically part of the buyer’s due diligence, and involves an analysis of balances at the account level over a set period – the previous three, six, 12 months, and so on. The time period is sometimes tough to agree on as it can have a material impact on the amount of working capital, especially for businesses with fluctuating working capital demands throughout the year.

The specific definition of NWC is also hotly debated. For example, at what point is inventory considered obsolete? Is it 60 days, 120 days, 180 days, 360 days, or some other length of time? At what point is an account receivable no longer considered good? Are receivables still considered collectible at 120 days?

Stage #3 – The Purchase Agreement

Objective: Define working capital and how it will be calculated in the purchase agreement to help prevent disputes.

The purchase agreement is the official document that defines the terms of the transaction, including the working capital calculation. It sets out how NWC will be calculated, and states which account balances are included or excluded in the definition. A comprehensive definition of working capital in the purchase agreement reduces the potential for litigation.

For clarity, a sample net working capital calculation should be included as an exhibit in the purchase agreement. The more detail the parties agree to regarding the calculation, the lower the likelihood of disputes post-closing (Stage #5). Ideally, the purchase agreement should be as detailed as possible.

Stage #4 – Closing

Objective: Estimate the amount of working capital for closing calculations.

Working capital is estimated at closing. It can’t be set in stone at this point because the final account balances won’t be available until three to four months after closing.

Stage #5 – Post-Closing Settlement

Objective: Working capital is reconciled or “trued up” 60 to 120 days post-close. The actual amount of working capital the buyer receives is compared with the target, and any difference is reconciled between the parties.

This reconciliation process prevents the seller from eroding the working capital before closing for their benefit. For example, the seller could liquidate inventory or speed up collection of accounts receivable to increase their cash proceeds.

The NWC delivered at closing directly affects the purchase price. If NWC comes in above target, the buyer will pay the seller the difference, resulting in a higher purchase price. If NWC comes in below target, the seller will pay the buyer the difference, resulting in a lower purchase price.

The Working Capital Cycle

When examining the amount of working capital required to operate a business, it’s helpful to know the working capital cycle, or the amount of time it takes to convert working capital into cash. Companies that turn over inventory fast and immediately receive payment from customers, such as most retailers and B2C companies, can operate with minimal working capital. The prime example is grocery stores, which famously operate with a negative working capital balance. They can do so because they’re paid for inventory by customers before they have to pay for it themselves.

Businesses that require a low amount of working capital are usually more scalable than those that require more, unless they’re “asset-intensive” and require a significant investment in long-term assets, such as machinery and equipment.

The working capital cycle, or cash conversion cycle, is illustrated in further detail below:

How to Reduce Net Working Capital

Business owners can optimize cash flow, improve short-term liquidity, and reduce working capital by optimizing three primary areas – inventory, receivables, and payables.

• Reduce inventory:
  • Increase the inventory turnover ratio – i.e., cost of goods divided by average inventory
  • Improve the inventory-to-sales ratio – i.e., net sales divided by average inventory
  • Increase the inventory sell-through rate
• Reduce the accounts receivable:
  • Increase the accounts receivable turnover ratio – i.e., net credit sales divided by average accounts receivable – by aggressively collecting receivables
  • Decrease sales outstanding receivables – i.e., average accounts receivable balance divided by total revenue multiplied by days in the period – by aggressively collecting receivables
• Increase accounts payable:
  • Decrease the average accounts payable turnover ratio by slowing down payments to suppliers

Example of a Positive Working Capital Cycle

Businesses with a positive working capital cycle usually require an infusion of capital or an operating line of credit to finance the period between paying for their inventory and receiving payment from customers. In the following example, Acme Chocolates’ inventory starts with raw materials:

• Acme Chocolates orders inventory on credit and has 50 days to pay for it
• Acme Chocolates sells its finished chocolate in 45 days
• Acme Chocolates receives payment from customers within 15 days
• Working Capital Cycle = 45 + 15 – 50 = 10 days

Example of a Negative Working Capital Cycle

Businesses with a negative working capital cycle can operate in a deficit. Acme Groceries receives immediate payment from customers when selling their goods and pay for inventory on terms:

• Acme Groceries purchases inventory on credit and has 90 days to pay for it
• Acme Groceries, on average, sells its inventory in 45 days
• Acme Groceries receives payment from customers immediately (zero days)
• Working Capital Cycle = 45 + 0 – 90 = 45 days

Metrics such as days sales outstanding (DSO), days payables outstanding (DPO), and days inventory outstanding (DIO) flesh out a company’s cash conversion cycle. They are useful in estimating the amount and timing of cash flows and, therefore, of working capital.

But buyers are cautious and on the lookout for significant recent changes to these metrics, which may indicate manipulation and unsustainable change. So, any improvements should be made well before the sales process begins, should be clearly sustainable and, ideally, already maintained over several quarters.

Why a Net Working Capital Target?

Working capital fluctuates for most businesses throughout the year and is also subject to manipulation. For example, inventory can be rapidly sold off and reserves not replenished, accounts receivables aggressively collected by offering discounts, and prepaid expenses reduced. All such actions can reduce working capital in the short term, but they may not be sustainable over longer periods.

How NWC can be Manipulated

The seller could manipulate working capital in one or more of the following ways:

• Aggressively Collecting Receivables: If a company normally collects accounts receivables in 45 days, the seller can offer incentives for customers to pay early, say, in 25 days. If accounts receivables average $5 million for a business but the seller leaves only $3 million in receivables in the business, the buyer will receive $2 million less in cash in the months following the close.
• Extending Accounts Payable: The seller could extend accounts payable so the burden of the extended payables rests with the buyer. Instead of paying vendors in the typical period, that is, 15 days, a business can stretch its payments to 45 days. The buyer would then assume a larger accounts balance at closing, which in some cases can amount to millions of dollars.
• Liquidating Inventory: Finally, the seller could reduce the company’s inventory reserves. Then, when a buyer takes over operations, they would need to inject additional capital to increase inventory to normal operating levels.

The Benefits of Using a Net Working Capital Target

In M&A, buyers and sellers agree to a specific or set amount of working capital to be included in the purchase price. This is known as a target or “peg.” For example, a $50 million purchase price may include $5 million in working capital. If the amount of working capital delivered at closing is then calculated to be $4 million, the seller owes the buyer $1 million via a purchase price adjustment, or working capital adjustment.

So, using a defined target reduces friction between the parties. It means they can agree on how much working capital will be included in the purchase price without having to worry if the actual amount will vary between signing the LOI and the closing date. A working capital adjustment prevents it from being manipulated before then, and assures the buyer that enough capital will remain in the business to maintain operations. Working capital adjustments are crucial in situations in which working capital is subject to change before closing.

Negotiating the Target

Negotiating the target is critically important. If the target is set too high, a seller could leave money on the table. Too low, and the buyer will have to inject additional cash into the business after closing.

A working capital target protects both parties. It protects the buyer by reducing the purchase price if the amount of working capital delivered at closing is less than agreed. And the seller will receive a higher purchase price, via a purchase price adjustment, if they deliver working capital above the target.

The target protects the buyer from other issues, too. For example, many businesses don’t maintain an allowance (or reserve) for bad debt, an omission the buyer may discover during due diligence. If maintaining a reserve is industry practice, an adjustment should be made to NWC to include one. If this adjustment isn’t made, working capital will be overstated by the amount of the reserve.

A working capital target protects both parties.

Why is NWC Included in the Purchase Price?

From a buyer’s perspective, working capital – which includes accounts receivable, inventory, and prepaid expenses – is necessary to maintain the ongoing operations of a business. It’s similar to any other asset required to operate. Most sophisticated buyers negotiate to include working capital in the purchase price when they submit an offer, and a wise one will negotiate to include a target to ensure it’s not manipulated or eroded before closing. This ensures the buyer has enough capital to operate the business from then on.

Tips for Sellers to Address NWC Before the Sale

Sellers should consider the following when preparing for a working capital analysis:

• Balance Sheets: Ensure all your balance sheet accounts are properly reconciled and up to date.
• Financials: Have your financials reviewed or audited. Hire a firm to perform a QoE analysis so methodologies for calculating working capital are consistent with generally accepted accounting principles (GAAP) or accounting practices in your industry.
• Accounts Receivable: Make sure all accounts receivable are collectible so they don’t adversely affect the working capital calculation. Write off any uncollectible accounts.
• Inventory: Make sure physical inventory checks have been conducted correctly, that inventory is properly booked, and reserves are in place to account for obsolete inventory. Regularly count and verify inventory to ensure the balances are up to date. If inventory is overstated, there could be a shortage post-close that results in lost sales, and a claim could be made against the escrow, reducing the purchase price.
• Accruals: Review accrual policies, correct improper accruals, or implement proper reserves that can affect accrued accounts and notes payable. An example would be if paid time off is not accrued properly or at all.
• Revenue and Expenses: Ensure revenue and expenses are being properly accrued. Working capital is usually restated using the accrual basis if the financial statements are prepared on a cash basis, which helps match revenue and expenses more accurately.
• Deferred Revenue: Establish a liability for customer deposits or advanced collections and properly book deferred revenue.
• Prepaid Revenue: When customers prepay for goods or services, book revenue only after the goods or services have been provided. If they have not been delivered, revenue (and cash) isn’t technically earned and shouldn’t be booked.
• Terms: Ask vendors to extend terms in writing. If you have historically paid accounts payable past the deadline and those terms aren’t in writing, the buyer is unlikely to include those balances when calculating accounts payable. Any additional terms granted to you will reduce NWC and result in additional cash in your pocket at closing.
• Customer Deposits: Properly account for customer deposits for future work, which are usually considered an exception to the cash-free, debt-tree concept. The buyer will expect you to leave any customer deposits as cash in the business, so it’s best to keep them in a separate bank account and only treat them as pay once they’re earned.

Tips to Reduce Working Capital

If a seller tightens the working capital cycle several quarters before the sale, they demonstrate the change is sustainable. From a buyer’s perspective, this tightened working capital cycle reduces the risk associated with estimating the working capital target. The longer this new norm is maintained, the more likely the buyer will accept it. As the seller, every dollar you reduce the working capital before closing effectively goes into your pocket at the closing table.

You can tighten the working capital cycle in the following ways:

• Accelerate the collection of accounts receivable
• Extend supplier credit terms to market norms
• Increase inventory turns (the time between buying and selling items)
• Reduce the overall operating or process cycle times

As a seller, every dollar you reduce the working capital before closing effectively goes into your pocket at the closing table.

Components of Working Capital in M&A

The Major Components of NWC

The following are the major components of net working capital:

• Current assets
  • Petty cash
  • Inventory
  • Accounts receivable
  • Prepaid expenses
• Current liabilities
  • Accounts payable
  • Accrued expenses

Petty Cash

Most acquisitions occur on a cash-free, debt-free basis – the result is that cash and cash equivalents are not included in the calculation of working capital. The primary exception is petty cash for retail businesses.

Inventory

Inventory is one of the largest components of net working capital, the other being accounts receivable.

The Inventory Count

When it comes to valuing the inventory, one of the key issues is whether the parties plan to physically conduct an inventory count at closing or rely on the business’s perpetual inventory-taking.

If inventory is counted on a perpetual system, the calculation can be rolled forward from the last physical count. In most cases, the buyer will diligence the accuracy of the perpetual system to accept this methodology.

A physical inventory count can be time-consuming, but not taking one at closing poses risks to the buyer. They may not be able to resolve stock issues later because inventory can’t be counted retroactively. On the other hand, if a buyer counts inventory on their own, the seller may challenge the methodology. In many industries, there are recommended third-party firms that specialize in counting inventory for you.

How Inventory is Valued

How inventory is valued is another key issue. The purchase agreement should address whether it is valued using FIFO (first in, first out) or LIFO (last in, last out), or the lower of cost or market value, and what’s considered obsolete or damaged inventory. Failing to clarify these points can lead to post-close disputes.

FIFO vs. LIFO

LIFO reflects a more accurate picture in an inflationary environment. The LIFO reserve account reflects the difference between LIFO and FIFO since the date LIFO was adopted. In an inflationary environment, this is a contra-inventory account and reduces the value of inventory. As a result, this increases the cost of goods sold and reduces EBITDA.

Accounts Receivable

Bad Debt Reserve

Most businesses carry a bad debt reserve on their financial statements. A reserve for bad debt is subjective to some degree, and many purchase agreements define how the reserve will be set for calculating working capital. Other businesses don’t carry a reserve and only write off bad debts as they occur. For them, it’s more appropriate to determine a suitable reserve and include it when calculating working capital.

Using a Formula

If the strength of the accounts receivable is unknown, a formula may be used in which aged receivables are valued lower than newer receivables. For example, receivables less than 30 days old may receive 95% credit, from 30 to 60 days a 90% credit, from 60 to 90 days an 80% credit, and over 90 days a 50% credit. Past a certain number of days in aging accounts receivable, a buyer will likely not recognize the value of invoices and they’ll be written off. Or, the working capital can be calculated based on the receivables collected, though this may delay the true-up if they remain uncollected after it is scheduled.

Valuing Accounts Receivable

The most common approach to valuing accounts receivable is to determine the receivables net of a general reserve for doubtful accounts. But, it’s important to understand on what basis the reserve was calculated so it can be updated for changes in the business. For example, if the reserve is calculated based on a percentage of total accounts receivable or revenue, it should be increased as the value of accounts receivable or revenue increases. Reserves can either be general, where they apply to all accounts receivable, or specific, where they apply to a single account receivable, such as one that’s slow-paying or otherwise in trouble.

Accounts Receivable and the Value of Your Business

For the seller, aggressively collecting your receivables is an opportunity to realize additional value, but only if you do so for several quarters before you begin the sales process. If your receivables are normally collected in 60 days – days sales outstanding, or DSO – and you manage to reduce this to 30 days, you have effectively put 30 days of receivables in your pocket at the closing table.

Accounts Payable

The largest component of working capital on the current liabilities side, accounts payable consists of outstanding invoices due to third parties, such as suppliers, vendors or contractors.

Defining Which Payables Are Included

The challenge is determining which payables to include in calculating working capital. Ideally, the payables included should be listed in a schedule to the purchase agreement, and a formula should be agreed for defining how long a payable can be floated before it must be paid. This prevents the seller from delaying payables in an attempt to reduce working capital. While the actual amounts will change, the accounts and vendors will have been identified and a formula accepted to prevent disputes.

Tracking Payables

Many small to mid-sized companies don’t accurately track their payables. They may pay all invoices on delivery (COD) and carry few payables on their balance sheets, even though vendors may offer them terms of net 30. This allows sellers to realize additional value before they begin the sales process. As a business owner, you should stretch your payables as long as possible to minimize the amount of working capital required to operate. If vendors offer a discount for early payment, these savings must be weighed against the reduction in working capital.

Days Payable Outstanding

Past a certain number of days in accounts payable, the buyer will consider those invoices effectively funded debt and exclude them from the calculation. To counter this, ask for full terms from vendors in writing and develop a pattern of paying invoices within the maximum term available.

Accrued Expenses or Liabilities

The remainder of working capital consists of accrued expenses and liabilities. Accrued expenses are those you owe that have not yet been invoiced, or in some cases, won’t receive an invoice.

Examples include accrued employee expenses, such as vacation, paid time off, bonuses and other benefits, and utilities. Most smaller businesses don’t properly accrue expenses on their balance sheets, but it’s wise to do so consistently before you begin the sales process. This’ll help ensure an accurate working calculation and reduce potential disputes. Properly accruing expenses before the sale means you can make changes to your business to reduce the total accrued expenses, and therefore the amount of working capital.

For sellers, aggressively collecting receivables is an opportunity to realize additional value.

How NWC is Calculated

When is working capital calculated?

The working capital peg is usually first estimated at the LOI stage of an M&A transaction. This preliminary calculation is a starting point for the process and, like many terms in the LOI, isn’t legally binding. The final working capital calculation is made 90 to 120 days after closing and any difference is reconciled between the parties via a purchase price adjustment.

When do working capital adjustments happen?

A working capital adjustment takes place 90 to 120 days after closing. This gives the buyer enough time to review the calculations and determine the amount actually delivered at closing. At this point, all accounts are closed – e.g., all accounts receivable have been collected – and the buyer can arrive at a more accurate working capital figure.

Period for the Working Capital Calculation

Several factors, such as seasonality and the timing of the closing, determine the time period on which to base the net working capital target. But what about best practices?

Historical Average

In most cases, buyers estimate working capital based on a historical average, typically an average and normalized or adjusted NWC for the trailing 12 months.

Choosing the Right Period

The average period could be shorter, such as the last three or six months, if such a period better reflects the operations of the business, or the near-future outlook. Best practice is to use a longer time period to smooth out any abnormalities, seasonality, rapid growth or decline in revenue, which can throw off the calculation. If the buyer is valuing the business based on historical EBITDA, working capital should also be measured using historical, not projected, financial information.

Seasonality and Other Issues

When calculating NWC, you should also consider how seasonal or cyclical the business is. In a three-month average, the calculation will be skewed depending on where it falls in the year. Timing of the closing may also impact the calculation. For example, in a large commercial cleaning business we represented, the sale closed in the off-season, and the accounts receivable was 80% down on the busy season. Luckily, in this transaction, we negotiated to exclude working capital from the purchase price, which is rare, but it allowed us to eliminate potential disputes regarding the timing of the calculation.

Art vs. Science

Calculating the working capital target is both an art and a science. The science lies in calculating the balances for all of the accounts that comprise it. Art comes into play in identifying normalizing, non-operating, and non-recurring adjustments to working capital and to what extent these should be included or excluded in the definition. Unfortunately for the seller, these adjustments are often identified by the buyer during their financial due diligence, which gives them leverage to propose a calculation weighted in their favor. A seller can counter this by undertaking a QoE analysis before the sales process begins. The QoE should include a working capital analysis, which will establish a favorable calculation and supporting narrative.

Example Calculation

Let’s examine a sample calculation using a seasonal service business.

As you can see, working capital is 250% higher ($2.5 million vs. $1 million) in the busy season than the off-season. As the seller, if you haven’t defined working capital and how it’ll be calculated in the LOI, you’ve just written the buyer a check for $1.5 million because they’re sure to use the calculation based on the busy period.

Accounting for Seasonality

Calculations based on the trailing 12 months will naturally factor out seasonality. But the amount of actual working capital delivered at closing will differ depending on when the purchase is made. If the transaction closes during peak season, working capital will be higher than average, and the buyer will need to inject cash at closing to sustain current operations. If the transaction is completed off-peak, working capital will be lower than average.

Other Considerations to Address

Another example includes a business that has made significant changes to its practices or activities in the prior 12 months that might affect the working capital accounts.

For example, the business may have won a new client by offering lenient payment terms. If the client was won recently, these terms may need to be accounted for in the working capital calculation. If management switched from a LIFO to a FIFO inventory valuation method, they may need to account for this too. There are numerous changes a business can make that affect the working capital required to operate or how it’s calculated.

To minimize the impact of any recent changes, I recommend not basing the working capital estimate on shorter periods as they may inadvertently favor one party or the other.

The Impact of Not Adhering to GAAP

Most small to mid-sized businesses don’t strictly adhere to generally accepted accounting principles (GAAP), which leads one to wonder why they’re called generally accepted at all. Regardless, if the financials don’t conform to GAAP, then the monthly balance sheets may not include the necessary accruals to calculate working capital on a GAAP basis.

Alternative Methods

Working capital can also be analyzed on a historical basis as a percentage of revenue. For example, the working capital accounts can be calculated at the end of each month over the past six and compared with either revenue or costs of goods sold each month, and then a percentage established.

Preventing a Negative Impact on Business Value

To prevent an erosion in value, it’s best, as the seller, to undergo a QoE analysis before you begin the sales process, and work to define working capital as clearly as possible in the LOI. Twelve months is the most commonly used timeframe as it incorporates seasonality in the business’s cash flow. If you own a seasonal business, it’s best to specify that an average of the last 12 months will be used as the basis for the NWC calculation, if you can get the buyer to agree.

Last Twelve Months (LTM) Average Method

A 12-month analysis isn’t usually appropriate if your company is rapidly growing. With growth comes a need for an additional infusion of capital. A working capital calculation based on the last 12 months would therefore not be sufficient to support the revenue in the months immediately following the close.

If revenue grew 50% in the trailing 12 months, the working capital delivered at closing would be higher than a target based on a 12-month average, resulting in a significant purchase price adjustment post-close.

For businesses with normal growth trajectories, the most common method to establish the NWC target is to take the average month-end balances of each working capital account over the past 12 months. Using the LTM average of each working capital account, you can then determine the average NWC for that period.

Example NWC Calculation #1

The following is a sample calculation for a business with a busy season from May to August. Amounts are in millions, and the final column shows the last twelve months’ (LTM) average.

In this case, the average NWC is $4.3 million, which would be delivered to the buyer on closing.

Example Calculation #2 – NWC at Close vs. the Target

Scenario #1: NWC higher than the target

• Net Working Capital at Close: $12,000,000
• Net Working Capital Target: $10,000,000
• Excess NWC: $2,000,000
• Adjustment: The buyer will pay an additional $2,000,000, via a purchase price adjustment, because the seller delivered working capital at close that was higher than the target.

Scenario #2: NWC lower than the target

• Net Working Capital at Close: $22,000,000
• Net Working Capital Target: $26,000,000
• Deficit NWC: $4,000,000
• Adjustment: The seller will receive $4,000,000 less, via a purchase price adjustment, because they delivered less working capital at close than the target.

Additional Considerations in Calculating NWC

The following are additional items that should be considered when performing a working capital calculation:

• Cash vs. Accrual Basis of Accounting: Working capital may need to be recalculated using the accrual basis if the business has historically prepared financial statements on a cash basis. This is common in smaller transactions where recordkeeping is based on money in, money out.
• GAAP vs. Non-GAAP Accounting: Another common issue is when a seller doesn’t follow generally accepted accounting principles (GAAP). Any change in accounting practices could significantly affect the NWC calculation, or the financials may need to be restated using GAAP. For example, accounts payable may be underreported and may need to be properly booked. Unrecorded expenses may also need to be examined, such as accrued bonuses, sales commissions, payroll, etc., or a bad debt reserve established. Most of these adjustments will not be made until after the buyer’s financial due diligence, and can often take the seller by surprise.
• Month-End vs. Year-End Accruals: The differences between interim and fiscal periods may affect the working capital calculation as significant year-end adjustments impact the average NWC. Working capital calculations based on interim periods aren’t as accurate as calculations based on year-end balances. Year-end adjustments to many working capital accounts aren’t performed during interim periods. The monthly balances may need to be adjusted to normalize all the months and calculate an average that’s more representative of the working capital balance, rather than incorporating the impact of a one-time, year-end adjustment.
• EBITDA Adjustments: Adjustments to EBITDA can also affect working capital calculations, for example non-operating expenses such as transaction-related professional fees. They may also be recorded as an account payable but may need to be excluded from the working capital calculation. Non-recurring expenses, such as severance expenses, may also need to be excluded from the calculation. Other examples include aged accounts receivable or payable, obsolete inventory, or non-operating accounts payable – such as capital expenditures, income tax-related liabilities, related party balances that aren’t operating, or payment terms that aren’t arm’s length.
• Pro Forma Adjustments: Pro forma adjustments present NWC using similar assumptions used to prepare projected or pro forma income statements, which can be retroactive or forward looking. These adjustments may include the impact of acquisitions and divestitures, operational efficiency improvements, expected revenue and cost synergies, the impact of new products or services, accounting methodology changes, added or eliminated executive positions, and so on.
• Deferred Revenue: Advanced collections and customer deposits must be addressed. In a cash-free, debt-free transaction, the buyer is obligated to provide services to customers post-transaction, even if the related cash remains with the seller. Any deferred revenue should therefore be accounted for and addressed in the working capital calculation.
• Quality of Current Assets and Completeness/Adequacy of Current Liabilities: Recorded balances for current assets and current liabilities may not accurately reflect their real economic impact. For example, allowances against aged accounts receivable may not reflect reality, and an increase in the allowance for doubtful accounts to accommodate an increased risk of collection will be a working capital adjustment. Current liabilities may be understated, or certain liabilities not recorded, or certain obligations not reflected in the financials. Reasons may include the seller’s materiality threshold differing from the acquirers, or liabilities not being quantifiable, such as environmental liabilities or the impact of litigation. If the liability can’t be quantified, other mechanisms may be created to address the liability, such as indemnification by the seller or more stringent representations and warranties in the purchase agreement.

Any change in accounting practices could significantly affect the NWC calculation.

Negotiating the NWC Target

The Major Elements for Negotiating NWC

There are two major elements to the negotiations:

• The Target: Parties have opposing interests when negotiating the target. The buyer prefers a high target, while the seller prefers the lowest possible. The common ground is for the target to sustain normal operations. Insufficient working capital delivered at closing will require the buyer to inject additional cash or increase their borrowing post-close.
• The Formula: This involves negotiating the formula for calculating the actual working capital for the target, for use at closing and in the true-up.

Tips for Negotiating NWC

The following can help when negotiating both the target and the formula:

• Start Operating With Less NWC Early: Historical trends are a sound baseline for establishing the target. The argument that a buyer can operate the business with less working capital than it required in the past is difficult to justify without evidence. For the seller, the best proof is to operate the business with less working capital for several quarters before closing. If you can sustain the changes, the buyer will struggle to refute them.
• Get a QoE Analysis: The party that leads this discussion has the upper hand in negotiations. If you want the upper hand as a seller, hire a QoE firm to prepare a working capital analysis in advance. This will provide you with advice on how to reduce working capital in your business and develop a defensible calculation by properly accounting for its various components. Investing in a QoE analysis before going to market is generally cheaper than legal and accounting fees to resolve NWC disagreements post-close.
• Normalize Financial Statements: Normalize your historical financial statements to account for changes that may occur post-close and affect NWC for the buyer. For example, consider excluding one-time extended accounts receivable terms if they won’t exist going forward.
• Learn About NWC Before the Sale: Develop an early and basic understanding of NWC and how it factors into the deal. This will alleviate some stress and uncertainty in the run-up to closing.

Conclusion

When it comes to selling your business, details that seem small now can have a tremendous impact on the amount of cash you take away from the closing table. When it comes to the concept of net working capital, such details can become a ticking time bomb, set to explode even months after closing. If you aren’t keen on ticking sounds at your meetings, then it pays to educate yourself on the concept of NWC, and to take the advice outlined in this article when it comes to preparing your business for sale.