What is Net Working Capital, and Why Is It Important?
The net working capital mechanism is crucial in M&A transactions, and for good reason: it’s a calculation of the working capital that the buyer will need to continue operating a company and meeting its obligations after the transaction closes. It’s important to understand and calculate this figure accurately, otherwise both parties could find themselves navigating net working capital purchase price adjustments.
First, Let’s Define Net Working Capital
Net working capital is accounts receivables plus inventory minus accounts payables and accrued expenses. Put another way, it’s a company’s current assets minus its current liabilities. Since most transactions occur on a cash-free, debt-free basis, the buyer of a company typically assumes these financial items when the deal closes, so it’s important for both parties to determine an accurate target working capital figure.
The seller of a company provides the buyer with a normalized level of net working capital — meaning this is what both parties believe is an appropriate and fair level of net working capital that accounts for daily fluctuations. The buyer’s expectation is that it will receive that working capital after the deal closes in order to continue sustaining the target company’s core operations and financial obligations.
However, depending on financial performance, market conditions, and other decisions made by the seller of the company, the target net working capital can change — resulting in a purchase price adjustment when both parties go to close the deal.
Situations Requiring Net Working Capital Purchase Price Adjustments
As part of the M&A transaction, an escrow account is established to handle funds between the buyer and seller. Because net working capital can fluctuate in the normal course of business, it’s important to verify it after the transaction closes. This is called a post-close true-up or a post-close adjustment.
- If the net working capital is short, this is called a negative purchase price adjustment and the buyer can look to the seller to be made whole
- If the net working capital is above the target working capital, the buyer will be responsible for a net working capital purchase price adjustment
As an example of the latter, the target business to be acquired could continue to grow, generate more receivables, or expand its inventory to support increasing demand. In this instance, the asset end of the assets-minus-liabilities formula is larger and results in a higher net working capital, thus necessitating a purchase price adjustment.
A good way to think about net working capital purchase price adjustments is that they’re ultimately about ensuring both parties in an M&A transaction are protected and that the transaction is executed fairly. Ultimately, the most ideal situation is that there is no net working capital purchase price adjustment required when the deal closes.
Work with MelCap to Navigate Your Transaction Successfully — and Mitigate Net Working Capital Purchase Price Adjustments
At MelCap Partners, we advise clients on both the buy-side and sell-side of M&A transactions as well as their partner accounting firms to ensure a smooth, beneficial process for all parties. For more than two decades, we’ve supported organizations across multiple industries ranging from retail and food & beverage to healthcare and private equity. Explore our most recent transactions here along with what our clients had to say about working with us.
With our highly experienced team guiding your path forward as well as a relentless commitment to service and success, we’re the partner you’ve been looking for to advise you on your most important transactions. Our team has consistently been recognized for our leadership and involvement in M&A transactions for major brands nationwide. Learn more about our awards and recognitions here.