Working capital in M&A is a somewhat neglected and misunderstood topic. Buyers and sellers often have different expectations. As a result, we recommend that this topic be addressed early in negotiations, and definitely before signing an LOI. The LOI should clearly indicate the purchase price and other terms (cash at closing, earnout, employment agreements, escrow, etc.) as well as the amount of required working capital at closing that the seller will deliver as part of the transaction.
In general, working capital, also known as net current assets or NCA, equals current assets (cash, accounts receivable, etc.) minus current liabilities (accounts payables, accrued and deferred expenses, line of credit, current portion of long-term debt, etc.).
In M&A transactions, the Target (or Required) Working Capital comes into play. Simplified, the target working capital is the minimum amount of working capital, on a cash-free and debt-free basis, required at closing such that the buyer can operate the business post-closing without the need to add any cash or debt. The closest analogy would be the “gas in the tank” any car buyer expects from the dealer when buying a car and driving off the lot.
Many business owners struggle with the idea of “leaving” money behind that they believe is theirs. However, the working capital cannot be separated from the business. The purchase price a buyer offers is for a “going concern” and assumes that there is enough on the Balance Sheet to allow the business to continue to operate in the foreseeable future.
Technically, on a cash-free / debt-free balance sheet, the Equity, which includes Retained Earnings, equals Current Assets minus Current liabilities, which is working capital. If the seller was to “keep” the equity, there would be no working capital left for the new owner to run the business.
| Current Assets | 100 | Current Liabilities | 50 | |
| Equity | 50 | |||
| Total Assets | 100 | Total Liabilities and Equity | 100 |
Calculating the Target Working Capital (TWC) is mostly a science, but also an art because each situation is different and is subject to interpretation and negotiation: Which period should be used? TTM (Trailing Twelve Months) before closing or the most recent calendar year? How should the amount be determined if there is an earnout? Or rollover equity? How should deferred revenue be treated? What if revenues are decreasing or increasing? How are accounts receivable that are more than 120 days past due treated? How are short-term spikes in the level of working capital treated?
As mentioned, an offer to acquire a business should include next to the purchase price and other terms the amount of working capital required at closing calculated on a cash-free / debt-free basis as an average of the monthly working capital in a given period, like TTM, the last calendar year, etc.
Finally, on the day of closing, the Net Working Capital is determined and the purchase price/ cash at closing amount is adjusted dollar for dollar depending on if the Net Working Capital is lower or higher than the Target Working Capital. Typically, after 90 days a true-up takes place, to determine the final working capital at closing and the necessary adjustment.
How are the target working capital, the adjustment at closing, and the amount the seller receives from the Balance Sheet calculated?
Below are the steps related to the treatment of the Working Capital. In addition, we can provide you with a real-life Excel-based calculation that you can request by sending us an email at mergers@excendio.com
Start with 12 monthly Balance Sheets side by side in an excel. Separate in two columns:
- The cash-free / debt-free line items the seller will deliver to the buyer at closing (Current Assets including accounts receivables, prepaid expenses, inventory; Current Liabilities including accounts payable, accrued liabilities, deferred revenues, etc.), and
- The line items the seller will be responsible for at closing (cash, shareholder notes, line of credit, long-term debt, etc.).
Next step: Determine the 12 months average of the items in column 1. The Target Working Capital equals the sum of all averaged current assets selected in column 1 minus the sum of all averaged current liabilities selected in column 1.
The Net Working capital at closing is the difference between the current assets and current liabilities line items identified in step 1 above on the day of closing.
At closing, the purchase price is adjusted on a dollar-for-dollar basis depending on if the Net Working Capital is lower or higher than the predetermined and agreed Target Working Capital.
What are the net proceeds for the seller from the Balance Sheet at closing? To determine this amount, first calculate the difference between the assets and liabilities in column 2 (which represents the items that are the seller’s responsibility at closing). The net impact for the seller from the Balance Sheet at closing is the sum of the working capital adjustment and the amount representing the seller’s responsibility. The net impact can be a positive or negative amount.
Finally, 90 days after closing a true-up takes place, after the Actual Working Capital at closing has been determined.
Other sources discussing Working Capital in Mergers & Acquisitions transactions that we found very relevant include:
BY CRISTIAN ANASTASIU
Managing Director, Excendio Advisors