LUTZ BUSINESS INSIGHTS
Understanding Net Working Capital in Business Transactions
BILL KENEDY, MERGERS & ACQUISITIONS SHAREHOLDER
The treatment of net working capital (typically defined for M&A transaction purposes as all non-cash current assets less all non-debt current liabilities) is frequently a topic of debate in potential deals.
- We often perform valuations for clients involved in the potential sale or purchase of businesses and have seen buyers and sellers disagree over how net working capital figures into the purchase price.
- We have seen some sellers who believe that they should receive the value of their company based on income or market-based valuation approaches, plus also be able to retain any net working capital of the business (which in many cases is comprised primarily of uncollected accounts receivable). The issue with this approach is that the value of a company based on income or market-based valuation approaches is dependent upon the company being delivered to the buyer with a sufficient amount of net working capital to support the business as reflected by its current income.
Therefore, if a seller delivers a company with insufficient working capital (because the seller has retained these assets), then the buyer would need to fund this working capital shortfall, which would effectively increase the capital required to purchase the business. Knowledgeable buyers, however, will not pay full price for a company that will not be delivered with the level of net working capital necessary to fund operations.
A certain level of net working capital is required to support a business’ sales levels. Companies typically operate with a certain amount of accounts receivable, inventory and prepaid assets which are offset by current liabilities such as accounts payable and accrued expenses. In certain circumstances, a company may have excess working capital as of the valuation date caused by an unusual event such as a spike in receivables. This could lead to an upward adjustment to the company’s value. A simple approach to determine whether an upward adjustment for excess working capital is appropriate is to examine the company’s historical working capital levels. But prospective sellers should be aware that buyers typically expect working capital at the closing of the transaction to be equal to the most recent twelve months average working capital (based on dollars or percentage of revenue).
If a company has had net working capital levels of approximately 12% of sales over the past five years, it can be reasonably estimated that the company will continue to require that level of working capital to support future sales. Therefore, it may be appropriate to add any working capital amount in excess of 12% of sales as of the transaction closing date to the determined company value as excess working capital (essentially a non-operating asset). A related adjustment may be made that would reduce the company’s value for insufficient working capital if the company had a net working capital balance below its historical levels as of the valuation date. Although this may seem like an increase or decrease to the sale price, that is really not the case. Remember, cash is excluded from the calculation of net working capital so if at closing the working capital is under the target that means the business likely has more cash as of the transaction closing date which is retained by the seller. So there would be no net cash impact to the seller after accounting for this cash on the balance sheet.
As with many valuation topics there is no cookie cutter answer for how to deal with working capital targets. The important thing to remember is that net working capital balances need to be considered in any transaction and that delivering a company without sufficient net working capital will only lower its purchase price at closing. We recommend to our clients to spend time analyzing their working capital to ensure they receive maximum value at the time of sale. For instance, if a Company typically pays all of its vendor invoices well in advance of when they are due, that Company’s net working capital (net of cash) is running higher than it should be going in to a transaction. The buyers will likely look at the average of the net working capital over the prior twelve months and that will be their expectation at the closing of the sale. But if this company were to begin paying their vendor bills on time instead of paying early a year or more in advance of a sale, the seller will retain more cash when the Company is sold because its working capital target will likely be lower.
A transaction can be structured in a number of different ways that may result in a buyer assuming various different levels of the net working capital of the acquired business, but sellers need to be cognizant that this will impact the purchase price at closing. At the end of the day the seller should ultimately end up with the same value, whether that value is comprised entirely of cash or a mix of cash and retained assets.
ABOUT THE AUTHOR
BILL KENEDY + LUTZ CONSULTING AND M&A SHAREHOLDER
Bill Kenedy is a Lutz Consulting and M&A Shareholder at Lutz. He specializes in business valuation, litigation support, and merger and acquisition advisory services.
AREAS OF FOCUS
AFFILIATIONS AND CREDENTIALS
- American Institute of Certified Public Accountants, Member
- Nebraska Society of Certified Public Accountants, Member
- Certified Public Accountant
- Accredited in Business Valuation
- Certified in Financial Forensic
- Certified Exit Planning Advisor
- BSBA in Accounting, St. John’s University, Collegeville, MN
- Construction Financial Management Association, Past Treasurer, Board Member
- A Time to Heal (non-profit focused on cancer patients), Past Board Member
- Net Working Capital: What is it and How is it Used?
- Issues During the Due Diligence Process in M&A Transactions
- Lutz M&A Advises Fantasy's, Inc. on its Acquisition by Casey's General Stores
- Primary Benefits of Selling Your Company to an ESOP
- Is An Employee Stock Option Plan Right for Your Business?
- Lutz M&A Advises C&W Transportation on its Sale to Platform Capital
- Our Services, Our People, and Our Results
- Lutz M&A Advises Hands of Heartland on its Recent Investment by Evolve Capital
- Lutz M&A Advises Labor Source on its Recapitalization by Great Range Capital
- Overcoming Obstacles in Business Transition Planning
- Understanding Net Working Capital in Business Transactions
- How to Increase the Value of Your Business
- When is the Right Time to Exit My Business?
- Lutz M&A Advises Triage Staffing on Recapitalization
- Lutz M&A Advises Hockenbergs on Recent Sale to Trimark USA LLC
- Lutz M&A Advises Focus Respiratory on its Recent Buyout by Valley Healthcare Group
- Is Your Small Business at Risk of Fraud?
- Lutz M&A Advises CCW, LLC on its Recent Buyout
- Lutz M&A Advises NIFCO Mechanical Systems on Recent Sale
- Lutz M&A Advises Midwest Door & Hardware on Recent Sale
- Why is Forensic Accounting Needed?
SIGN UP FOR OUR NEWSLETTERS!
We tap into the vast knowledge and experience within our organization to provide you with monthly content on topics and ideas that drive and challenge your company every day.
13616 California Street, Suite 300
Omaha, NE 68154
747 N Burlington Avenue, Suite 401
Hastings, NE 68901
601 P Street, Suite 103
Lincoln, NE 68508
3320 James Road, Suite 100
Grand Island, NE 68803