Why Net Working Capital Must be Considered in Transactions

The treatment of net working capital (typically defined for transactions purposes as all non-cash current assets less all non-debt current liabilities) can be a topic of debate in potential transactions. 

• We often perform valuations for clients involved in the potential sale or purchase of businesses and have seen buyers and sellers disagree over how net working capital figures into the purchase price. 
   
• We have seen a number of sellers who believe that they should receive the value of their company based on income or market-based valuation approaches plus be able to retain any net working capital of the business (which in many cases is comprised primarily of uncollected accounts receivable).  The issue with this approach is the fact that the value of a company based on income or market-based valuation approaches is dependent upon the company being delivered to the buyer with a sufficient amount of net working capital to continue business as usual.

Therefore, delivering a company with no working capital (because the seller has retained these assets), results in the buyer needing to fund this working capital shortfall out of its own pocket, which would effectively increase the purchase price.  Knowledgeable buyers, however, will not pay full price for a company that will not be delivered with the level of net working capital necessary to operate the business effectively.

A certain level of net working capital is required to support a business’ sales levels. Companies typically operate with a certain amount of accounts receivable, inventory and prepaid assets which are offset by accounts payable and accrued expenses. 

In certain circumstances, a company may have excess working capital as of the valuation date, which could lead to an adjustment to its value.  A simple approach to determine whether an adjustment to value for excess working capital is appropriate is to examine the company’s historical working capital levels.  If a company has had net working capital levels of approximately 12% of sales over the past 5 years, it can be reasonably estimated that the company will continue to require that level of working capital to support future sales.  Therefore, it may be appropriate to add any working capital amount in excess of 12% of sales as of the valuation date to the determined company value as excess working capital (essentially a non-operating asset).  A related adjustment may be made that would reduce the company’s value for deficient working capital if the company had a net working capital balance below its historical levels as of the valuation date.      

As with many valuation topics there is no cookie cutter answer for how to deal with working capital.  The important thing to remember is that net working capital balances need to be considered in any transaction and that delivering a company without sufficient net working capital will only lower its value. 

A transaction can be structured in a number of different ways that may result in a buyer assuming all or none of the net working capital of the acquired business, but sellers need to be cognizant that this will impact the purchase price.  At the end of the day, though, the seller should ultimately end up with the same value, whether that value is comprised entirely of cash or a mix of cash and retained assets. 

If you have questions regarding the information in this article, the details of working capital, or are considering the purchase or sale of a business, please call me or any of the professionals in our Businees Valuation and Litigation Advisory Group at (855) MARCUM1.