Negotiating on NWC

April 23, 2022

by a searcher from Tulane University - A. B. Freeman School of Business in Austin, TX, USA

Wanted to get some feedback here. We're working on an LOI for a commercial landscaping company and are going back and forth with the owner on working capital. We're coming up with an approach where we give the owner all of the AR, and we take the inventory as part of our purchase price. We'd get a line of credit to finance working capital, which we're OK with, and we think this would get them to give us the inventory (they originally said WC was 500k, not including inventory which they'd want us to by - no go). My question is: do we run a risk of the owner front-loading the AR and billings aggressively before close, and how could we protect ourselves against that through terms in the LOI or otherwise? Or even more broadly, is this a bad idea?

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Reply by a searcher
from University of Pennsylvania in Charlotte, NC, USA

Agree with all the above. I realize you're negotiating an LOI and not a purchase agreement, but one forms the basis for the other, and it sounds like there is confusion around the working capital component of the purchase price. A detailed definition of the components of NWC is key, as is a definition of cash and indebtedness or debt-like items that will be treated as indebtedness. One way to accomplish this is to take the current/historical balance sheet, and specify which line items are included or excluded from a NWC calculation. Come to negotiated agreement on that and agree that there will be a post-closing true-up. It often makes sense to also have seller present its calculation of NWC at closing (with our without a closing true-up, but at minimum serving the purpose of confirming at closing that seller and buyer are playing by the negotiated rules.) Include a schedule in the closing documents that presents the company's closing balance sheet annotated for what is included or excluded in the NWC calculation, and ideally the rationale for why if there might be uncertainty. Of course, all this and more, such as a dispute resolution mechanism, needs to be documented accordingly in the purchase agreement.

Reply by a professional
from Georgia Southern University in Atlanta, GA, USA

Having a detailed definition of working capital with the balance estimated at closing followed by a post close adjustment is key and helps align the interests of both parties. As others commented, there's a lot of risk in your approach. Seller could advance bill customers, stop buying inventory, sell current inventory at discounts to accelerate AR/cash, stop paying vendors, etc. All of these can be avoided through the use of a working capital target and a clear definition of indebtedness. You can have special clauses for treatment of certain AR/inventory outside of working capital, but an overarching target should still be used.

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