Understanding Net Working Capital

Entrepreneurs considering a sale or purchase of a business often ask how assets and liabilities carried on the company’s balance sheet -- including cash, accounts receivable, inventory, security deposits, trade payables, unearned revenue and more -- are incorporated into the sale.

After all, many companies carry significant amounts on their balance sheet, and the line items are in constant flux, driven by the sales cycle. How do you capture the value of inventory in a sale? If AR shoots up before a sale, if inventory is unusually low, or if the seller takes in deposits before a sale for work to be provided after the sale, what is the impact on the transaction?

The answers to these and other questions stemming from the balance sheet are all usually negotiated in an asset sale via the “net working capital adjustment.” 

When used properly, the net working capital (NWC) adjustment incorporates balance sheet fluctuations into the sale. But to avoid nasty last-minute misunderstandings or surprises, the buyer and seller need to understand and agree how net working capital will be addressed.

Here is a basic explanation of how a NWC adjustment might work. Once you have the basics, it’s easier to understand various complications and nuances.

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First, net working capital is your current assets, minus current liabilities.

‍More assets increase NWC, and more liabilities decrease NWC.

Let’s assume hypothetical Company A has a very simple balance sheet with just $400,000 in collectable accounts receivable and $1 million in saleable finished goods inventory; and on the liability side, $200,000 in accounts payable and $100,000 in prepaid revenue deposits. The NWC for Company A is $1,100,000. 

          $(400,000 + $1,000,000) – ($200,000 + $100,000) = $1,100,000 

In a very simple asset sale, the buyer may provide a letter of intent that states that in addition to the value of the company, the cash delivered at closing by the buyer to the seller would be increased dollar for dollar for positive net working capital, or decreased dollar for dollar for negative net working capital at closing. For Company A, cash paid to the seller at closing would increase by $1,100,000. The buyer collects and keeps the AR when it comes in, pays the payables when due, and fulfills the unearned revenue obligation.  

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However, with a larger business or more complex transaction, a buyer will generally request some working capital be included in the proposed purchase amount. The amount of NWC the buyer expects to be included is called a “threshold” or “target,” and it is generally a point of negotiation along with the overall proposed purchase amount. The cash paid to the seller at closing could be increased or decreased based on the amount of net working capital over or below the threshold or target.

The target amount may be a fixed dollar amount, average NWC, or an amount of NWC required for some time period. There are several methods and issues to consider when calculating NWC over time, especially if your business has any cyclicality. All the advisors in the transaction need to understand which method is being used, and why. When the NWC adjustment starts to get complicated, it can help to include an example of the calculation in the purchase documents to ensure everyone is on the same page.

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Now, let’s add some additional complexity:

• Certain defined assets and liabilities may be excluded from the sale. For example, cash in the seller’s bank account is usually retained by the seller and not included in the transaction or in the calculation of the NWC target or NWC at closing. The letter of intent should clearly describe which assets and liabilities on the balance sheet are included or excluded in the transaction, and included or excluded in the NWC calculation.  
• Let’s assume that Company A is approaching a sale and in the week before closing, a client pays $300,000 they owe in receivables. Now Company A has $100,000 in AR, $100,000 in liabilities, zero net working capital, and no additional cash paid to the seller at closing. Is the seller upset? No, because that $300,000 in cash has been paid by the client, and the seller is keeping all the cash in the bank accounts.

Here are three key points to consider as you approach a sale:  

1. Make sure your balance sheet is accurate and complete before you start the sale process.
2. Any letter of intent should define how NWC is to be addressed.  Don’t postpone the NWC negotiations until after the letter of intent (LOI) is signed. Some buyers like to include loose language like "The transaction will include an appropriate amount of net working capital." This type of language can decrease your value and you should insist on very clear language and a defined NWC target.
3. The closing documents should include a mechanism for which any changes or discrepancies that come to light after the sale can be handled.  

While it initially can seem confusing, when used correctly, the net working capital adjustment is a clean and simple way to ensure that the position of the company’s balance sheet at closing is incorporated into the value of the transaction.  

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