We have found that net working capital ("NWC") targets are one of the most commonly misunderstood components of M&A deals. While sometimes confusing, we believe sellers need to understand the logic behind NWC targets, as it can often become one of the more heavily negotiated items in M&A deals. If sellers have a better grasp of the what, how, and why of NWC targets, we believe it should make for a smoother negotiation to help get a deal to closing.

What is Net Working Capital? 

In nearly every transaction, a buyer will require a selling company to leave behind a defined minimum amount of working capital. A company uses working capital (current assets minus current liabilities) to fund its ongoing operations. In the context of M&A, buyers will view sufficient NWC as essentially the same as other assets purchased in the deal.

NWC = Current Assets – Current Liabilities

From a buyer's perspective, current assets such as accounts receivable (A/R), inventory, and prepaid expenses are all necessary to maintain ongoing operations. This minimum level of NWC is assumed as part of the valuation process and is included in the price (multiple) offered for acquiring the business. Therefore, a seller could expect a purchase price reduction if the actual NWC at closing is less than what was negotiated. 

Key Components to Understand: 

• Most M&A deals are structured on a 'cash-free, debt-free' basis, meaning the seller keeps the cash but is responsible for paying off any bank debts.
• NWC in M&A can differ from the textbook definition of current assets minus current liabilities. Buyers will only acquire those NWC items critical to running operations going forward.
• Typically excluded items include related party items, short-term debt and lines of credit, and taxes receivable/payable.

How are NWC Targets Determined for M&A Deals? 

In most cases, buyers will calculate a historical average (typically 12 months) to set an appropriate target that would need to be delivered at closing. The rationale is straightforward: a buyer is basing its valuation on revenue and EBITDA, and the working capital needed to generate that revenue and EBITDA will need to be provided (same as with other business assets). 

A seller needs to be cognizant that its EBITDA will usually reflect A/R as revenue and A/P as an expense, yet they remain uncollected or unpaid. Since the valuation is usually based on EBITDA, all items that went into EBITDA need to be accounted for. 

The Target-Setting Process: 

• Buyers typically use a 12-month average to determine a "normalized" level.
• This period helps average out fluctuations.
• The timeframe aligns with trailing the 12-month EBITDA typically used in valuations.
• The analysis involves a detailed review of balances at the account level. 

Why are NWC Targets Used? 

Sellers often mistakenly assume they can retain A/R post-close and/or aggressively collect and reduce A/R to keep more cash at closing. Since sellers keep the cash in most deals, this logic seems to make sense on the surface. However, a buyer would not be willing to pay full price if it based its valuation on EBITDA, which wasn't supported by sufficient NWC. 

How Purchase Price Adjustments Work:

• If NWC exceeds the target, sellers receive a dollar-for-dollar payment for the excess.
• If NWC falls below the target, the purchase price typically reduces dollar-for-dollar.
• If A/R is collected aggressively pre-close, buyers will likely discount the purchase price to offset the deficit.
• Even with a lower purchase price due to below-target NWC, sellers keep the collected cash, resulting in minimal net impact. 

Important Considerations for Sellers 

The purpose of NWC targets is to protect both parties from any gamesmanship on NWC levels, given the agreed-upon valuation. While sellers might wonder why this matters, there are two critical points to understand: 

1. Gaming the System Doesn't Work: Attempts to manipulate NWC levels likely won't provide any advantage, given the trigger mechanism of NWC targets.
2. Target Negotiation is Critical: The actual target-level negotiation is what truly matters. If a target is set too high, a seller could be forfeiting closing payments that would otherwise be coming to them.

Areas requiring particular attention during negotiations include:

• Balance sheet items that may be artificially high or low
• Buyer's due diligence findings that might affect historical balances
• Items that may need to be excluded from or included in NWC calculation 

Understanding Customer Deposits and Deferred Revenue 

One area that often creates confusion in working capital discussions is the treatment of customer deposits and deferred revenue. These items require special consideration, particularly for businesses that collect payments in advance or maintain long-term service contracts. 

Customer deposits represent advance payments for goods or services not yet delivered, while deferred revenue consists of payments received for services that will be delivered over time. Both present unique challenges in M&A transactions. 

Buyer’s Perspective 

These prepayments carry future obligations that the buyer will need to fulfill post-closing. Therefore, buyers typically expect: 

• The liabilities associated with these prepayments need to be properly accounted for in the transaction.
• Clear definitions of how these items will be treated in working capital calculations.
• Appropriate purchase price adjustments to reflect outstanding service obligations. 

Seller’s Perspective 

Sellers should be prepared to: 

• Provide detailed documentation of all customer deposits and deferred revenue.
• Understand that these items often require treatment separate from standard working capital calculations.
• Consider setting up escrow arrangements to address potential post-closing revenue recognition matters. 

The key is establishing clear agreement on these items early in negotiations to prevent misunderstandings and disputes during closing adjustments.

Navigate NWC Targets with Lutz 

Working capital targets are a crucial component of M&A transactions that require careful consideration and negotiation. With the help of an experienced and knowledgeable M&A advisor, sellers can navigate these waters and ensure NWC targets are set at appropriate levels. If you have any questions about working capital targets or other M&A matters, please contact us today.