There are trade-offs in every merger and acquisition transaction. Deals are finalized after both sides negotiate compromises. One of the issues that commonly affects the purchase price in an acquisition is the treatment of net working capital (NWC).
While the definition of what NWC is can vary by transaction, it generally is equal to non-cash current assets (accounts receivable, inventory, prepaid assets) less non-debt current liabilities (accounts payable and accrued expenses). The amount of NWC that a company needs to operate effectively differs by industry (and to some degree, even by the company).
For example, service businesses generally have lower NWC requirements because they can collect cash payments when their services are rendered and have lower inventory requirements. Manufacturers, on the other hand, often have more significant NWC requirements as a result of inventory balances and larger accounts receivable (for products shipped to customers prior to receiving payment). To the extent that a business has deficient (or excess) NWC as of a valuation or transaction date, it will correspondingly decrease (or increase) its value.
The issue we have seen regarding the treatment of NWC in transactions can occur when the purchase price for a company is based on income or market-based valuation approaches (both of which generally assume that the company is delivered with an appropriate amount of NWC at closing). For example, if the parties in a transaction can agree on the purchase price for a business based on these valuation approaches, but the seller also wants to retain all of the uncollected accounts receivable of the business (which are significant), then the business is likely to be delivered to the buyer with a deficient amount of NWC.
What does this mean? Unless the purchase price is adjusted downward for the expected NWC deficiency, the buyer will end up overpaying for the business because it will need to fund the NWC shortfall out of its own pocket. Knowledgeable buyers, however, will not pay full price for a company that is being delivered without sufficient NWC. Therefore, unless the seller is willing to adjust the proposed purchase price for the potential NWC deficiency (in our case, the assumption is that the seller wants to retain all uncollected accounts receivable), it is unlikely that a deal will be reached.
We have generally found it to be a best practice in transactions for the buyer and seller to reach an agreement on a NWC target (which is typically based on the selling company's historical NWC levels). To the extent that the selling company's NWC is in excess of (or less than) the target amount on the closing date, the purchase price is generally increased (or decreased) on a dollar-for-dollar basis.
With this in mind, transactions can be structured in a number of different ways as far as which assets and liabilities are retained by the seller and which are transferred to the buyer. The NWC target ensures that the purchase price is adjusted accordingly for these structuring differences as well as any material increases or decreases in NWC levels between the time that the target is set and closing. At the end of the day, the seller should end up with the same value for its business whether it is comprised entirely of a cash payment or is a mix of cash and retained assets.
For more information on the effect of net working capital on successful mergers and acquisitions, please contact your MarksNelson professional at 816-743-7700.