A contentious issue in M&A deals can often be the working capital adjustment that is embedded in the SPA. Albeit the term normalised working capital (NWC) may be familiar to many, its nuances are often misunderstood in the context of a purchase price adjustment as a part of the acquisition. This article discusses the fundamentals behind the working capital adjustment and how one can leverage the same to improve their position on something that often is a heavily negotiated point.

• Understanding Working Capital Adjustment Mechanism:

In terms of accounting, working capital may be defined as the difference between current operating assets and current operating liabilities. From the perspective of a business-owner it is simply the capital required to manage a company’s day to day activities. However, complexities arise when this traditional definitions or calculations are slightly modified from the viewpoint of an acquisition. The purchaser wants to ensure that the acquired business continues to meet its operational costs post-closing of the transaction and no further capital injection is required (which would have otherwise increased the effective purchase price). The Seller on the other hand, expects to be adequately compensated and is cautious about generating working capital which is more than was anticipated. Generally, most of these M&A transactions are completed by agreeing on an Enterprise Value on a cash free, debt free basis which assumes a normalised level of working capital. Once both parties agree on the amount determined as “normalised” (depending on the specific characteristics of the business), such amount is fixed as the “target working capital”. 

• How is Target Normalised Working Capital Calculated?

Typically, a target normalised working capital is based on the average working capital of the business for the latest 12 month period, because: 

• A full year average eliminates the impact of seasonality on normalised working capital.
• EBITDA, on which the agreed Enterprise Value is based, is also measured on the basis of results in the trailing 12 months.

In scenarios where the company subject to the transaction is growing rapidly and bids are based on forecasted EBITDA, then the target NWC should ideally be based on the forecast average NWC over the same period. Forecasted NWC may not often be available, so it is common to see Purchasers apply a growth rate expected to be achieved in EBITDA to historical NWC when calculating the NWC target.  A common belief amongst Buyers, is that if closing NWC exceeds the target NWC and the Buyer has to pay an additional post-closing adjustment, that they are somehow losing out. However, because the Buyer is receiving more NWC than expected there should be no net change in the equity value paid at closing.  Working capital adjustment mechanisms are often a difficult point of negotiation for both Buyers and Sellers in the context of acquisition agreements, in part because they lie at the intersection of corporate finance, accounting and law, but a well advised Buyer or Seller can take advantage of the adjustment mechanism to support its valuation model. This requires close coordination amongst all advisors involved in the transaction Cooney Carey has a dedicated team of experts to help you identify these issues and effectively execute such transactions.