Understanding Working Capital Impact on M&A Deals

Crain’s Cleveland BusinessIssued the week of Sunday, January 18, 2015

By Mark B. Bober

The way working capital is structured in any M&A deal can be an important consideration in the economics of the agreement.  A typical deal is priced on a debt free / cash free basis, so that the seller retains cash and also pays off debt with the proceeds of the deal.  This Net Working Capital [“NWC”] threshold or target is intended to protect the buyer and seller from manipulating working capital to the benefit or detriment of one party.

Typically, establishing an NWC target is not outlined in the early stages, or “Letter of Intent” stage, of the deal.  Rather, it is generally addressed during the due diligence stage, once the buyer has had a better opportunity to analyze the appropriate level of working capital to be pegged in the target.  The spirit of the NWC target is for the buyer to receive a business at a purchase price that leaves adequate working capital to operate the business.

Generally speaking, buyers and sellers often begin by analyzing historical working capital during a 12-18 month period in order to establish a trend. However, if the trend in revenues reflects growth, the expectation would be that the required level of working capital would increase. And if there are seasonal trends in revenue, then the timing of the closing could impact the NWC target.

Another area to consider is the impact of “debt-like” liabilities on the NWC target.  For example, if there is deferred revenue or customer deposits, this will need to be addressed, particularly given the typical deal is “cash free” [e.g. seller keeps cash]. Therefore, the buyer has the obligation to deliver on the promised product or service but the seller retained the cash.  This is one example of a consideration that needs to be analyzed with respect to net working capital, and the extent to which if treated as “debt-like,” identifying whether it is at the full amount of the deferred revenue / deposit liability or only the cost to fulfill the obligation.  Other obligations buyers and sellers must consider would include accrued bonuses, warranty claims and accrued / deferred commissions, to name a few.

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