The Economic Implications of Net Working Capital for Founders
- Why net working capital is a critical point of negotiation in a transaction
- How buyers try to manipulate the definition of net working capital to their benefit
- How an investment banker can negotiate this detail on your behalf
For founders who have never pursued an M&A or capital raise transaction, a small gap in knowledge around how typical deal dynamics work can have a significant impact on the final economic/cash payout.
A classic example is in the determination and calculation of the net working capital (NWC) target and associated purchase price adjustment. If not approached correctly, this detail—one a founder could easily overlook or be wholly unaware of—could result in a material reduction in the founder’s payout.
Negotiating a definition of net working capital and the associated target is not something you want to get wrong. Here are our thoughts on how to address this detail of the transaction, starting with a common misconception about enterprise value.
Enterprise Value ≠ Shareholder Payout
A common assumption is that the enterprise value of a company (i.e. the "valuation" as a multiple of revenue or EBITDA) is more or less the same as the final payout to shareholders.
What this assumption fails to take into account is that enterprise value represents the intrinsic value of a company independent of the company’s capital structure (i.e. debt vs. equity).
What does that mean exactly? In many cases, a company will be partially financed via debt, and shareholders only effectively own the portion of the company financed via equity (i.e. what is left over after the debt is repaid). So while the enterprise value of the company may be $90M, if the capital structure constitutes $20M in debt, only $70M of the enterprise value belongs to shareholders (their equity). In this case, when the company is purchased, assuming no other adjustments to the purchase price, $20M will go to pay off debt, and $70M will go to shareholders.
Adjusting for debt is just one of three primary adjustments that convert enterprise value to the final payout to shareholders.
The second adjustment is for cash—if a business has any cash in their accounts, the shareholders have title to that cash, which effectively increases the payout to founders. Together, the debt and cash adjustments make the transaction debt-free/cash-free.
You will also sometimes see the debt and cash adjustments combined into one adjustment called "Net Debt" which is simply Debt minus Cash. This adjustment can be positive, meaning debt is greater than cash, creating a downward purchase price adjustment.
Last of all is the adjustment for net working capital. Here is where founders, if not aware and careful, can unknowingly lose significant value in the transaction.
What Is Net Working Capital?
As you’re likely aware, net working capital constitutes the capital a company needs to run operations without liquidity issues. Based on the balance sheet, you calculate net working capital as current assets minus current liabilities.
Because working capital is essential to operations, when a transaction occurs, buyers want to ensure enough remains in the business to smoothly continue operations without additional funding from the buyer/investor.
Why wouldn’t enough working capital remain? Since sellers will receive the cash out of the business when the deal closes in the form of a purchase price increase, theoretically they could convert short term assets to cash and/or defer paying current liabilities before the transaction closes. If they did so, they would take out a larger cash balance than normal and leave insufficient working capital.
For example, a seller could tell a customer that currently has an accounts receivable balance of $50K that if they pay their invoice in the next 5 days they will receive a 50% discount on the invoice. Without a working capital adjustment this would be a net $25K (50% of the 50k invoice) positive cash purchase price adjustment to the benefit of the seller at the expense of the buyer/investor.
In order to protect buyers from situations like the above, a standard transaction will include a net working capital adjustment to the purchase price. In other words, the payout to founders will be adjusted up or down depending on whether the closing net working capital balance is higher or lower than a predefined net working capital target/peg balance.
For example, consider a transaction where both parties agree that a company should have $10M in working capital to operate. If at close there is $11M in working capital, then the purchase price would be adjusted +$1M. The same happens in the opposite direction.
Approached correctly, a net working capital adjustment keeps everyone honest and ensures a fair economic exchange. But this adjustment is still subject to manipulation, particularly on the buy-side. If founders aren’t careful, they could forfeit significant economic value based on how they agree to define the target working capital balance.
Defining the Net Working Capital Target/Peg
As mentioned, the net working capital purchase price adjustment is based on the difference between the net working capital on the closing date balance sheet and a target net working capital balance (often called a "peg"). The definition of how to calculate that peg is critical to the size and direction of the adjustment.
Some common points of consideration include:
- Will the peg be based on a 3/6/12-month historical average, or based on future projections?
- What balance sheet line items will we include in the definition of working capital?
- And others
What seems like a minor detail can measure up to a significant discount on the purchase price. To tilt the definition of net working capital in their favor, buyers will often introduce technicalities like the following:
Defining the peg based on go-forward projections. Common language that buyers will try to introduce in a term sheet is that the target company will carry "enough working capital to support the future growth of the company." In other words, the buyer wants to define a peg based on a future, projected balance. If the company is growing, then this definition will almost always result in a higher net working capital target, negatively impacting purchase price for shareholders given the larger business will inherently need more working capital. Depending on the aggressiveness of their projections, the difference could be significant.
Including deferred revenue in the adjustment for debt. For an enterprise SaaS company that collects cash from long-term contracts up front, they will have a sizable balance of deferred revenue listed as a liability on the balance sheet. Because the SaaS company hasn’t technically earned this money yet based on GAAP revenue recognition, buyers will suggest that this balance should fall under the adjustment for indebtedness.
If that were the case, companies could end up with millions chopped off the final purchase price despite the fact that deferred revenue doesn’t represent true debt. So instead of accepting deferred revenue as indebtedness, sellers should negotiate to have deferred revenue included in the net working capital calculation as a current liability. Doing so changes the economic impact on purchase price from a dollar-for-dollar reduction based on the deferred revenue balance to the change in magnitude of the deferred revenue balance over the evaluation period.
These are just two examples among many of how buyers can try to manipulate the definition of target net working capital.
Because the definition of the target balance can represent a significant delta in shareholder economics, this issue carries some of the most heated negotiation in a transaction. If you’re a founder who hasn’t run many transactions, knowing how to detect and negotiate these key points will be a significant challenge.
The Difference Is in the Details
Because so much of a founder’s economic outcome can hinge on seemingly minor details, having proper representation is critical. An experienced M&A advisor will stand in your corner and negotiate on your behalf on each point to ensure you achieve the best outcome possible.
Hiring an investment bank that specializes in sell-side transactions for founder-led companies is one of the best moves you can make.