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Net Working Capital (“NWC”), as a component of a purchase price true up is often the first post-closing milestone. Taking the time to fully understand and clearly define the parameters of NWC can mean smooth(er) sailing after an acquisition. Below, the team at SRS Acquiom offers perspective and tips to help reduce the risks of conflicts related to post-closing purchase price adjustments (“PPAs”) based on NWC.
What is net working capital?
At a simplified level, Net Working Capital (NWC) is a formulation of the difference between current assets and current liabilities.
A positive net working capital generally means your current assets exceed your current liabilities. Negative net working capital typically means your current liabilities exceed your current assets. NWC is a measure used to assess short-term financial health and operational needs of the company.
How does the net working capital definition in M&A differ from net working capital in accounting?
M&A Net Working Capital (NWC) usually excludes cash since cash is a separate part of total enterprise value. In a typical transaction, the purchase price will often be the negotiated price with the following adjustments: + cash +/- NWC - transaction expenses - indebtedness.
Additionally, there are often contractual adjustments specific to an M&A deal that exclude certain current assets or current liabilities from the calculation. For example, deferred revenue is often included in indebtedness rather than NWC. Certain tax liabilities are often excluded from the calculation altogether. They might instead be indemnifiable.
What are some common pitfalls in addressing net working capital as part of an M&A transaction?
- Net Working Capital Definition
The language most merger agreements often refer to is a combination of generally accepted accounting principles (“GAAP”) and the company’s past practices when defining how NWC should be calculated. But challenges and disputes arise if the company’s past practices are not consistent with GAAP or if GAAP permits various methodologies. To avoid these problems, the team at SRS Acquiom recommends the merger or purchase agreement should specifically state which method should prevail. - Setting the Net Working Capital Peg M&A
Setting the NWC peg can be difficult because M&A deal parties negotiate a NWC baseline weeks or months before actual numbers will be known. Often, the baseline is a rough estimate using the company’s historical balance sheet, which does not consider any transactional adjustments and often overlooks important matters such as seasonality of the business, extraordinary items, audit adjustments, and other factors. To ensure an accurate peg, use the historical balance sheet as a starting point and adjust for transactional items and updated reserve balances. - Treatment of Subsequent Information in an M&A Deal
The topic of subsequent information is an especially sticky one. GAAP requires certain subsequent events be disclosed in a company’s financial statements. In the context of a year-end audit, the auditor is required to review subsequent information and adjust existing balances accordingly. When reviewing subsequent information in the context of a purchase or sale, what should be included? The purpose of the NWC adjustment is to align the estimated figures to the actual figures on the date of closing. So, should deal parties be allowed to review subsequent information at all? If so, over what period? To navigate this gray area, the team at SRS Acquiom recommends the merger or purchase agreement should provide a time for which subsequent information can be considered.
Can purchase price adjustments (PPAs) be avoided?
Often the answer is no. According to the 2020 SRS Acquiom Claims Insights Report, 80%1 of M&A deals have a purchase price adjustment mechanism, and usually for good reason. In many cases, this mechanism is the best way to resolve issues about which party should get credit for certain adjustments and to reflect the economic deal agreed to in the transaction. The team at SRS Acquiom can help M&A professionals review PPAs and working capital provisions to help minimize post-closing risks. These tips can help with a head start in negotiating your next M&A deal to a smooth conclusion.
Footnotes
Julia Hoffman
Director, Escrow and Payment Solutions 703.380.1933
Julia is a director of Escrow and Payment Solutions for SRS Acquiom. She works directly with clients to manage all paying agent, escrow, and solicitation-agent engagements to ensure a smooth closing and post-closing process.
For four years prior, Julia was a Finance Director in the SRS Acquiom Professional Services Group where she focused on accounting matters related to purchase price adjustments, earnouts, and indemnification claims.
Before joining SRS Acquiom, Julia spent four years with Deloitte’s audit practice.
Julia earned her master’s degree in Accounting and Information Systems and bachelor's degree in Accounting and Information Systems from Virginia Polytechnic Institute and State University. She holds the CPA designation.