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Net Working Capital & Purchase Price Adjustments In M&A Deals

This article is part of a continuing series on recurring issues of critical importance to sellers in private company M&A. Previous topics include equity rolls. 

Net Working Capital (“NWC”) targets and purchase price adjustments are a nearly universal reality in private M&A deals, though often a neglected and misunderstood topic. To greatly simplify, the NWC target is the minimum amount of net working capital which the Buyer requires the acquired company to have at Closing so that the Buyer can operate the business without disruption and the immediate need to add significant cash or take on additional debt. A commonly used metaphor is the “gas in the tank” which any car buyer expects from the dealer when buying a car and before driving off the lot.  But should it be a half-tank or a full-tank? And exactly how big is that tank?  
 
Private M&A deals are typically priced on a “cash-free, debt-free” basis, meaning that the Seller is free to withdraw all cash from the business immediately prior to Closing. At the same time, the Buyer nevertheless expects that the Seller will not reduce NWC below the agreed upon NWC target. If NWC is properly defined and an appropriate target is agreed to, the effect of the NWC provisions should be “net neutral” and not benefit either party in terms of post-Closing purchase price adjustments. However, recent private M&A studies report a pro-Buyer NWC negative purchase price adjustment in 55% of deals and a pro-Seller positive adjustment in only 35% of deals. Pro-Buyer negative purchase price adjustments are often significant in amount and the result of improper planning and poor drafting. Since Buyers and Sellers often have decidedly different NWC expectations, this topic should be raised early in negotiations before signing any Letter of Intent.  Importantly, NWC issues should be carefully and fully negotiated and specifically defined in the definitive purchase agreement to avoid post-Closing disputes and to ensure a smooth transition of the business.
 
See below for an overview of certain of the key NWC factors a Seller should consider in any M&A deal.

Definition of NWC
 

• Typically defined as current assets, minus current liabilities, though “puts and takes” are common to arrive at “normalized” NWC
  • Determine the precise components of both current assets (e.g., cash and cash equivalents, accounts receivable, prepaid expenses, inventory) and current liabilities (e.g., accounts payable, accrued expenses, deferred revenue, short-term debt and the current portion of long-term debt) included in NWC
  • Identify any items that should be excluded from the NWC calculation (e.g., debt, cash, non-operating assets or excluded assets and liabilities)
  • Ensure there is a clear agreement between the Buyer and Seller on the included and excluded components of NWC
• If  separate purchase price adjustment processes are used for other components of classic NWC (e.g., “Indebtedness” or “Cash”), ensure that the provisions are harmonized, not dueling or resulting in double dipping
• Ensure that the accounting policies and practices used for all NWC calculations (e.g., GAAP vs. Seller’s historical practices) are agreed upon and favorable to Seller
• While perhaps viewed as boilerplate at first blush, NWC contract language is highly variable, often significantly negotiated, and the devil is definitely in the details

Setting the NWC Target or "Peg"
 

• Establish a target NWC amount based on historical averages or expected future operations; this serves as the baseline in determining any post-Closing NWC and purchase price adjustment
  • Analyze historical fluctuations in NWC to understand trends and anomalies
  • Use this trend analysis to support the NWC target and to anticipate potential disputes          
  • Consider seasonal fluctuations and business cycles in setting the target 
  • Assess the quality of the components of NWC, such as the collectability of receivables or the salability of inventory
  • Watch for any potential write-downs or reserves that may affect the value of NWC
• NWC target may be determined with reference to the date the deal was priced, the LOI was signed, diligence was completed or some other time
• A typical look-back period for determining a NWC target is 6-12 months
• The NWC target is typically determined toward the end of financial due diligence, often as a result of a quality of earnings analysis
• Include a NWC illustration using hard numbers as an exhibit to the definitive purchase agreement to avoid misunderstandings 

Post-Closing "True-Up" Mechanism
 

• Decide on the post-Closing mechanism for adjusting the purchase price based on the actual NWC at Closing vs. the pre-Closing NWC estimate
• Two-way, full dollar-for-dollar adjustments are common, though collars are sometimes employed
• Agree on the formula for calculating any post-Closing adjustment

Timing of Various NWC Calculations
 

• Agree on the timing of the preliminary NWC calculation, as estimated shortly before Closing, but as of the Closing Date
• Determine the period for any post-Closing final true-up or adjustment process calculating actual NWC on the Closing Date
• Seller typically prepares the initial estimated NWC calculation before Closing; Buyer typically prepares the actual post-Closing NWC calculation
• Typical Closing estimate date is 3-5 days before Closing; typical final true-up period is 60-90 days after Closing                                                             

 Funding of Any Pro-Buyer NWC Adjustments 
 

• How is any negative adjustment paid by the Sellers? 
  • From a separate NWC escrow? 
  • From the general indemnity escrow? 
  • Set off against other future payments due Seller, such as earnouts and other escrows?
  • Clawback if no funds are readily available?               

Dispute Resolution
 

• The definitive purchase agreement will set forth a post-Closing dispute resolution process for any disagreements regarding NWC calculations
• Often an initial “cooling off” period during which parties try to resolve
• Define the role of third parties, typically independent accountants, in resolving disputes in a non-judicial setting

Data Access
 

• Ensure access to necessary financial data and records for accurate NWC calculations
• Agree on the level of access the Buyer and Seller will have to relevant financial information of the other both pre- and post-Closing     

Representations and Warranties & Covenants
 

• Carefully review any representations, warranties and covenants related to NWC and working capital items
• Understand the implications of any breaches of these reps and warranties regarding the obligation to close and post-Closing indemnity claims 

Employee-Related Liabilities 
 

• Consider the impact of any employee-related liabilities (e.g., transaction, retention and other bonuses, vacation pay) on NWC
• Determine how these liabilities will be treated in the NWC calculation     

Regulatory & Compliance Issues
 

• Identify any regulatory or compliance issues that may impact the NWC (e.g., revenue recognition, inventory valuation)
• Ensure that the NWC calculation is in line with applicable accounting standards and regulations
• Be aware of any changes in accounting policies or regulations that could affect the NWC calculation and the comparability of the estimated NWC to the actual Closing NWC           

Contractual Obligations
 

• Review loan agreements and other contracts and obligations that may affect NWC (e.g., supplier agreements, customer deposit requirements)
• Understand how these obligations will be reflected in the NWC calculation and the overall deal                       

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The above executive summary has been prepared for general informational purposes only and is not intended as legal advice.  Sellers and Buyers alike are urged to consult their legal counsel concerning any particular situation and specific legal questions.

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