How to Understand Net Working Capital in Lower Middle Market Mergers and Acquisitions

Net working capital is one of the most contested elements we see in M&A transactions. It is often brought up close to closing a deal when emotions run high, which tends to amplify the confusion and anxiety surrounding it. Whether you are a buyer or a seller, preparing for a situation like this before entering into a transaction will help ensure a successful outcome at the negotiating table.

Most Lower Middle Market (“LMM”) transactions are structured as asset transactions and are cash and debt free. This means that the buyer is buying specific assets from the business, excluding cash in the bank and any debt. When a buyer makes an offer for a business, it assumes that it is buying a specific set of assets, which includes working capital items. Working capital is defined as current assets minus current liabilities.

A buyer assumes they will receive a specific amount of working capital, and often a working capital threshold is set to ensure that the amount of working capital they expect to get is delivered after closing.

The net working capital threshold is often discussed at the start of a transaction. The Letter of Intent (“LOI”) generally describes the approach to be used to calculate and measure working capital. The challenge at this point, however, is that the financial due diligence has not yet taken place. This means that buyers are unable to define the appropriate working capital threshold in the letter of intent. during financial due diligence.

The overall importance of working capital

Working capital has a potential dollar-for-dollar impact on the purchase price. Any purchase price adjustment is calculated by comparing the estimated working capital at closing (based on the closing balance sheet) to the predetermined working capital threshold. If the working capital at closing is above the threshold, the buyer can pay the seller the additional amount, which effectively increases the purchase price. If the net working capital at closing is less than the threshold, the proceeds are withheld at closing to make up the shortfall, which has the effect of reducing the purchase price. Therefore, the net working capital provided at the closing of the transaction has an impact on the cash paid or received by the buyer or the seller and is an important factor to consider when maximizing the value of your transaction. .

Example: calculation of net working capital at closing

Scenario A:
Net working capital close to $5,000,000
Net working capital threshold $4,000,000
Working capital surplus (deficit) $1,000,000
In this scenario, the buyer will pay an additional purchase price of $1,000,000 because the seller provided net working capital at closing above the threshold.

Scenario B:
Net working capital close to $3,000,000
Net working capital threshold $5,000,000
Working capital surplus (deficit) ($2,000,000)
In this scenario, the seller will leave $2,000,000 in cash to cover the shortfall. This can be from the cash on the balance sheet or from the overall purchase price minus $2,000,000.

How is the working capital threshold calculated?

A net working capital analysis is performed as a due diligence and is reviewed and approved by both parties. The intention is to mitigate any disputes regarding working capital. The threshold is generally calculated as an average of the net working capital on the balance sheet for the last 12 months. Twelve months is the most widely used period because it incorporates any seasonality a business may experience into its cash flow.

Working capital is the net of current assets and current liabilities. Since most transactions occur without cash or debt, cash is excluded from current assets. Current assets would include (but are not limited to) items such as accounts receivable, deposits, prepaid expenses, and inventory. Current liabilities would include (but not be limited to) items such as accounts payable, accrued liabilities, customer deposits, and deferred revenue.

The definitive purchase agreement will define the details of the net working capital calculation, and the calculation will be disclosed in a statement attached to the purchase agreement. The definition clearly indicates which account balances are included or excluded from net working capital.

How can I prepare for net working capital in my transaction?

The analysis performed on net working capital is the basis upon which the detailed definition of net working capital is found in the final purchase agreement. Therefore, the first (and best) thing you can do is make sure that all of your balance sheet accounts are properly reconciled and up to date. Below are some common accounting and balance sheet items that can affect the calculation:

• Cash accounting or accrual accounting: Most LMM businesses operate on a cash basis and are governed by taxation. Often, working capital is restated using the accrual method to better match income, expenses, and free cash flow.
• Aged customer accounts: Many LMM companies do not have a practice of writing off uncollectible accounts. It’s important to review your open accounts receivable and make sure everything is collectible. If accounts receivable are overstated in working capital at closing, a claim may be made against escrow after closing, reducing the overall purchase price.
• Outdated inventory or incorrect inventory: It is important for businesses to regularly count and check their inventory to ensure that their balances are up to date. If inventory is overstated, there could be a shortage after closing which results in lost sales, and a claim could be made against escrow, which would reduce the overall purchase price.
• Deferred revenue: When customers prepay for goods or services, most LMM companies recognize revenue when the cash is received, as it is normally cash. However, since the goods and services have not been delivered, this revenue (and cash) is technically not earned. This means that the buyer will have to supply the good or service after closing. A liability should be established for customer deposits or anticipated collections.
Ultimately, if you are unsure that you have correctly captured all aspects of working capital in your financial statements, it is a good idea to consult a management accountant who can help you reconcile your accounts and ensure a appropriate accounting compliance. Doing it in advance will likely save you significant time, headaches, and most importantly, dollars in the future.