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, the balance sheet is in constant flux, driven by the sales cycle. 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 – which happen in every single transaction. 

First, net working capital is your current assets, minus the current liabilities. Let’s assume hypothetical Company A has a very simple balance sheet with $400,000 in accounts receivable assets; and on the liability side, $50,000 in accounts payable and $50,000 in prepaid revenue. The NWC for Company A is $300,000. 

          $400,000 – ($50,000 + $50,000) = $300,000 

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 $300,000. The buyer collects and keeps the AR when it comes in, pays the payables when due, and fulfills the unearned revenue obligation.  

Your balance sheet is clearly not as simple as Company A, but more assets increase NWC, and more liabilities decrease NWC. As the balance sheet fluctuates, the net working capital adjustment fluctuates.

Now, let’s add some 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. 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. 
• Rather than zero net working capital, a buyer could request some working capital be included in the sale. The amount is called a “threshold” or the “target,” and it is often a point of negotiation. 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 to ensure everyone is on the same page.

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

1. Make sure your balance sheet is accurate 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.
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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