So you closed the deal you have been working on for months? You’re now the owner of a new company, and it’s time to start operating the business and realize the returns you have modeled. While you have been busy jumping through legal hoops, drafting purchase agreements, wiring funds, etc., the company has been continuing to operate as normal…right? Or have the outgoing owners been siphoning every dollar they can out of the business just to leave you with the burden of immediately injecting additional funds to the business to operate day one? This would not be an ideal start to the life of your new company, the one you have worked so hard to acquire. What is there to prevent the outgoing owners from doing just this? The answer to that question is a net working capital true-up.
What is net working capital and what role does it play in a deal?
If you ask most people with a financial background what net working capital means, they would probably reply with current assets less current liabilities. And that is the answer Google would give you. However, in the context of a transaction, the definition is slightly different. Almost all transactions are made on a cash-free, debt-free basis (i.e. the sellers will keep all cash remaining in the company at the time of close and will be responsible to pay off all debt). Therefore, the seller has a significant incentive to maximize the cash on hand at the time of close. One easy way to do this is to drain working capital out of the business. This can be done in a number of ways:
- Delaying paying vendors
- Incentivizing customers to pay their accounts receivable balance prior to close
- Depleting the inventory on hand
If this were to happen, you would have just inherited a company with no inventory, no receivables to be collected in the near future and a load of payables.
To protect the buyer from this scenario, transactions typically have a net working capital mechanism built into the purchase agreement. This requires the seller to provide a “normal” level of net working capital (excluding cash and debt) at close and is typically agreed upon during the diligence phase. The amount of net working capital to be delivered at close, referred to as the net working capital peg, can be set based on a number of different metrics, but the most common methodology uses the average of the last twelve months.
How do you determine the appropriate net working capital peg?
As part of the typical diligence process, a normalized net working capital level is typically defined. The goal of this is to reflect the working capital required to operate the company in a normal fashion over the period (e.g., no unusual events, accounting errors). Thus, during diligence, it is important to correctly identify any working capital adjustments so that an appropriate net working capital peg can be set. Some of the most common adjustments include:
- Properly accruing unpaid expenses / payroll
- Adjusting AR and inventory reserves to appropriate levels
- Removing non-operating payables/receivables related to the transaction
- Normalizing interim months (i.e., some companies only record or adjust certain balances at quarter or year-ends)
- Correcting accounting errors
Once a working capital peg is set, how is it used at close?
Once both parties have agreed on a normalized level of working capital, the amount is then compared to the working capital delivered at close. In most transactions, any difference between the peg and the amount delivered will adjust the purchase price on a dollar-for-dollar basis. For example, if a normalized level was determined to be $10mm and the company delivered $9mm, the amount of cash the buyer would pay at close would be adjusted downward by $1mm. In order to accurately calculate the amount of working capital delivered at close, it must be calculated in the same manner as it was when the peg was calculated. A significant amount of money can be lost by not carefully reviewing the calculation. As a buyer, the biggest risk is that the company did not consistently record all liabilities.
Here are 4 most common errors I see – plus ways to mitigate them:
#1: Not properly accruing all payables/accruals
Solution: Review payments made subsequent to close to ensure that all payments related to services provided prior to close were recorded as liabilities.
#2: Incorrectly applying NWC adjustments
Solution: Review the calculation provided by the seller to ensure all adjustments were included and were calculated correctly.
#3: Including uncollectible AR or obsolete inventory
Solution: Review the aging of the AR and inventory delivered at close to ensure you are not buying any assets that need to be written off.
#4: Not calculating net working capital at close in a consistent manner to the way the peg was set
Solution: Within the purchase agreement, the methodology for calculating net working capital should be clearly defined. Typically, this consists of what accounts will be included or excluded from the calculation as well as the manner in which any adjustments will be calculated.
How does this play out in real life?
Now let’s see how all of this comes together in a real-life example. We assisted a large public client (the seller) in preparing their NWC calculation in response to what the buyer had submitted. The buyer and their Big 4 advisors identified adjustments that required the seller to owe an additional $10 million. With detailed work and collaboration with the seller’s various finance teams, we were able to provide a NWC calculation that showed the buyer owing our client $2 million. Ultimately, the two parties settled with our client receiving approximately $600,000.
The above example required weeks of work given the complexity of the transaction. However, transaction advisors can also perform quick reviews that also provide value. Last year we assisted our client with recalculating the amount of net working capital the seller provided at close. We were provided the calculation just hours before it was due. During our quick review, we noticed that the seller had artificially inflated their working capital by $250,000. If we hadn’t brought this to our client’s attention, the calculated amount of net working capital delivered at close would have been wrong and cost our client approximately $250,000.
Although it is easy to get lost in all the more glamorous aspects of a deal, neglecting net working capital can set a new company up for problems day one. It is important to accurately model a normalized level of working capital when evaluating a company and to ensure it is delivered at close.
Alex Brinkman, CPA, is a Manager in Moore Colson’s Consulting Practice. He works in the Transaction Services Group helping both financial and strategic clients with mergers and acquisitions.