Buyers and sellers often agree that the selling company’s valuation assumes that the company will be sold on a cash-free, debt-free basis, with a normalized level of net working capital (“NWC”). To make sure you leave enough NWC in the business, you and the buyer will negotiate how much is enough. $300k? $1M? $2M?… $5M?
We all know the correct definition of working capital (Current business assets – current business liabilities = net working capital), but when you’re buying or selling a business, the formula is never that simple. Often cash is excluded from the formula. Or, if it’s included, it is commonly defined to ensure that only a normal operating minimum of cash is required as of closing (with the balance to be withdrawn by the seller). The buyer will want as much working capital as it can get, while the seller wants to keep as much cash as possible because he feels that cash accumulated is really in large part a measure of his past operations. Accordingly, the balance sheet rarely transfers from seller to buyer without adjustment to the purchase price, regardless of whether the transaction is structured as a sale of assets or stock. Working capital is always in flux, so the level at the purchase date is naturally important.
One major part of negotiating during due diligence is agreeing on the working capital target amount and agreeing on the formula for calculating the actual working capital for the company at closing and in the true-up (post-close). The normal purchase agreement will commonly state the anticipated working capital to be purchased, based on a normal operating level, and then will provide for a post-closing adjustment, to either add to or subtract from the purchase price, if the working capital level is markedly different from what would normally be expected.
As we all learned in accounting 101, insufficient capital to cover business expenses is one of the main reasons for business failure. That’s why net working capital is an important indicator of your business’s financial health, for your company and buyers, and lenders too. The more working capital you have, the “safer” the investment in your company is in the short-term.
Historical trends can be an important baseline for establishing a target working capital level. One of the key areas in financial due diligence is a net working capital investigation, in addition to a quality of earnings analysis. Often these analyses may have a potential positive or negative dollar impact to the buyer or the seller as part of a transaction. In most cases, since months have passed between the date of the initial offer to the actual closing date when the buyer acquires the company, a purchase price adjustment may be necessary to reflect changes in the seller company’s updated financial condition.
The selling company’s closing NWC should be an amount enough for the business to generate the same amount of cash flow used in determining the purchase price. Commonly, this is referred to as a “normalized level of net working capital.” This, however, may not be the same as the expected level of NWC at the time of closing. The normalized level of NWC is what the parties believe to be a fair level of NWC for the business as reflected in the pricing model, adjusted to account for normal day-to-day fluctuations in net working capital.
In establishing such norms, buyers may have concerns about current and solid cost basis for inventories (no least of cost or market adjustment required), collectible status of receivables, and proper reporting and clean accrual of earned liabilities to the date of closing.
In determining the closing NWC, buyers will look back at such final tally to do a “true-up” post-close. Naturally, it is critical that the parties utilize the same measurement mechanisms to assess. Measurements utilized by the seller in its operation of the business are often not refined to the level the buyer would expect for determining the closing date amount. Many privately-held businesses only book adjustments to reserves for bad debt, or write-offs of aging inventories one a year, as they move toward a year-end closing. Accordingly, such write-offs may not have been adjusted properly at an interim close date. A detailed study of all GAAP-required reserves will be important to the final settlement of a closing working capital tally.
Finally, when selling your business, NWC and NWC adjustments are not meant to be a big financial windfall for the seller or the buyer. Often some small portion of the purchase price will be required to be set aside, in cash, for significant post-closing adjustments which would have reduced purchase price under terms of the deal.