Net Working Capital in a Deal-Making Environment

What is net working capital? NWC is a measure of operating current assets providing near-term benefits and operating current liabilities obligating the company. It’s critical in allowing business operations to run smoothly and to continue to meet their immediate financial obligations. Current assets represent a business’s liquid resources and short-term investments that are expected to be converted into cash or consumed within a year, aiding operational liquidity. Current liabilities are debts and obligations due within a year, reflecting short-term financial responsibilities and liquidity requirements. Since working capital equals the difference between current assets and liabilities, it can be either positive or negative. Outlining an approach and methodology for NWC calculation within the letter of intent (LOI) is crucial to avoiding potential issues when drafting the purchase documents. Search fund entrepreneurs often emphasize accurate NWC calculations to mitigate risks and ensure the acquired business remains financially stable. Adjustments are often made during financial due diligence for definitional, due diligence, and pro forma items. For instance, cash- and financing-related items would be excluded from the NWC calculation in cash-free and debt-free transactions. Additionally, adjustments can be made to reflect non-operating, non-recurring, or other normalization items. Understanding the net working capital peg The ultimate goal of a net working capital mechanism within a deal is to ensure the company has sufficient working capital to continue normal operations. Establishing a net working capital peg is a key negotiation item that will generally be determined during financial due diligence. The NWC peg is a benchmark, or baseline, amount of net working capital that is agreed upon by both the buyer and the seller. It’s an important factor in M&A transactions, serving as a reference point to ensure fairness and transparency between the involved parties. The NWC peg is often calculated using a trailing average of the target company’s NWC, subject to adjustments. By averaging over a set period, the oscillations in NWC smooth out to protect both the buyer and seller. For certain transactions, this may differ depending on unique facts and circumstances such as seasonality or recent growth trends. Ensuring fairness for both parties The agreed-upon NWC peg acts as a fair and neutral value, reflecting the working capital needs of the target’s business. At the time of closing, any difference between the actual NWC of the target company and the NWC peg results in a dollar-for-dollar adjustment. This mechanism protects both the buyer and seller, aligning their interests in the M&A transaction. Often, a buyer and seller may agree to a collar around the NWC peg that results in no adjustment should the delivered working capital fall within the established range. Beyond fairness, the NWC peg safeguards buyers against unexpected fluctuations in working capital. In the event of such fluctuations, assessing whether the new NWC level represents an optimal state at completion becomes crucial. This safeguard ensures that sufficient working capital is retained in the business post-closing.