You Can’t Have Your (Net Working Capital) Cake

and Eat it Too!

What is net working capital? The definition of net working capital is not fixed, and the meaning may vary by industry. It is also a key factor in a valuation and understanding there is a deficiency or excess will impact the value of the company and structure of an acquisition.

[su_pullquote align=”right”]Resources:

Linking the Market Approach to the Income Approach: A Simulation Study

Dissecting the Net Working Capital Adjustment Provision

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At some point in all our lives, someone has told us (or we have had to tell our children) that “you can’t have your cake and eat it too.”

This figure of speech illustrates the concept of trade-offs (if you eat your cake, you do not have it anymore), a key component of every M&A transaction.  Rarely does a deal close without both parties making compromises from their ideal scenarios to reach an agreement.  If a buyer or seller faces an issue in which they demand to be in the superior position regardless of the outcome (and to the detriment of the other party), they may be trying to “have their cake and eat it too.”

One of the issues we have seen creep up in previous negotiations relates to the treatment of net working capital (NWC) in an acquisition and its impact on the purchase price.

The definition of what constitutes NWC can differ in each transaction, but it generally is equal to non-cash current assets (accounts receivable, inventory, prepaid assets) less non-debt current liabilities (accounts payable and accrued expenses).  The amount of NWC that a company needs to operate effectively differs by industry (and to some degree, even by company).  For example, service businesses generally have lower NWC requirements because they can collect cash payments when their services are rendered and have lower inventory requirements.  Manufacturers, on the other hand, often have more significant NWC requirements because of inventory balances and larger accounts receivable (for products shipped to customers prior to receiving payment).  To the extent that a business has deficient (or excess) NWC as of a valuation or transaction date, it will correspondingly decrease (or increase) its value.

The issue we have seen regarding the treatment of NWC in transactions can occur when the purchase price for a company is based on income or market-based valuation approaches (both of which generally assume that the company is delivered with an appropriate amount of NWC at closing).  For example, if the parties in a transaction can agree on the purchase price for a business based on these valuation approaches, but the seller also wants to retain all the uncollected accounts receivable of the business (which are significant), then the business is likely to be delivered to the buyer with a deficient amount of NWC.

This means that unless the purchase price is adjusted downward for the expected NWC deficiency, the buyer will end up overpaying for the business because it will need to fund the NWC shortfall out of its own pocket.  In other words, the seller may be trying to have its cake and eat it too.  Knowledgeable buyers, however, will not pay full price for a company that is being delivered without sufficient NWC.  Therefore, unless the seller is willing to adjust the proposed purchase price for the potential NWC deficiency (in our case, the assumption is that the seller wants to retain all uncollected accounts receivable), it is unlikely that a deal will be reached.

We have generally found it to be a best practice in transactions for the buyer and seller to reach an agreement on a NWC target (which is typically based on the selling company’s historical NWC levels).  To the extent that the selling company’s NWC is in excess of (or less than) the target amount on the closing date, the purchase price is generally increased (or decreased) on a dollar-for-dollar basis.

Remember, transactions can be structured in several different ways as far as which assets and liabilities are retained by the seller and which are transferred to the buyer.  The NWC target ensures that the purchase price is adjusted accordingly for these structuring differences as well as any material increases or decreases in NWC levels between the time that the target is set and closing.  At the end of the day, the seller should end up with the same value for its business whether it is comprised entirely of a cash payment or is a mix of cash and retained assets.

Having your cake and eating it too sounds great, but if you are not willing to share (by making trade-offs and compromises where appropriate), you may end up eating alone.

Sean R. Saari (Sean), CPA, ABV, CVA, MBA, manages Skoda Minotti’s Valuation & Litigation Advisory Services group and is responsible for helping clients address their valuation, litigation support, tax, financial reporting, strategic planning, and business advisory needs. He joined Skoda Minotti over 10 years ago and assists a diverse client base. He has authored more than 75 articles, e-books, blogs, and whitepapers and is a regular speaker, both locally and nationally, on valuation, litigation support, accounting, and tax issues.

Mr. Saari can be contacted at (440) 605-7221 or by e-mail to ssaari@skodaminotti.com.