Determining Net Working Capital

By Jan H. Raymond

When sellers negotiate the terms of a sale transaction, they think first and foremost about the “sale price”. However, at Logisyn, we focus on maximizing the “net proceeds” to our client. In other words, we focus not on some “number” that might look good on paper, but, rather, how much of that number ultimately finds its way to the pockets of our client.

There are a number of items that may impact how much of the stated sale price actually results in net proceeds. These include, among others, tax implications from the deal structure, earn-out provisions and warranty claims. We will discuss those in separate articles, but this article will address another one of the items that can affect net proceeds: “net working capital”.

When a buyer “values” a business, they look at the value based on the way that the business is currently operating (either based on the last twelve months or an average of one or more prior years). However, the business is able to operate (and generate profits) at that level in part because of the amount of capital it has on hand to fund those operations. As such, if the business had less capital than the amount needed to operate at that level, it would be “undercapitalized” and therefore would not be able to operate at that level and derivatively, be less valuable. That is the rationale for why a buyer will require that the seller deliver the business with the amount of net working capital that was presumed to have been required to operate the business at the level upon which it was valued in agreeing upon the sale price.

Net working capital is a defined term meaning that it has an agreed upon standard definition: current assets minus current liabilities.

• Current assets are cash and cash equivalents, prepaid expenses and accounts receivable.
• Current liabilities are accounts payable and short-term debt (debt payable within twelve months).

Like all balance sheet items, current assets and current liabilities, and therefore, net working capital, fluctuates daily. As such, in determining how much net working capital was actually needed to fund operations at the level upon which the business was valued requires a review of the net working capital levels over a period of time; typically the same period of time that was used in valuing the company but not more than one year. This is a time-intensive data driven exercise that is part of the due diligence process. Once the buyer has performed this exercise and presented their analysis, the seller must review that analysis to either confirm or dispute the buyer’s conclusion; a time-intensive data driven exercise for the seller.

Once the parties have agreed upon a net working capital figure, this is deemed the net working capital “target”. At the Closing, the net working capital on that date will be calculated and then compared to the net working capital target. Any overage will be credited to the seller and any shortfall will be debited from the seller.

Since the net working capital can materially affect the net proceeds of the sale, it is important that negotiation of the agreed formula and methodology to be used in calculating net working capital be done early in the sale process and that this calculation be done precisely and accurately. Logisyn focuses on maximizing net proceeds to its client, so as a result we work closely with the seller to assure that the net working capital negotiation and analysis are conducted at the highest professional level to assure that the seller’s interests are protected and net proceeds maximized.

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