Business acquisitions fail all the time due to misunderstandings surrounding net working capital (NWC).

Here’s a crash course on what you need to know if you're buying a business.

Why does it matter? Simply put, NWC matters because it impacts the purchase price.

When you buy a business, you're purchasing a collection of assets based on the cash flow you expect them to generate in the future.

One of those assets is the net working capital of the business.

If the business is delivered with insufficient working capital, the buyer would need to inject additional capital to fund operations.

This effectively increases the purchase price.

Therefore, the purchase price should include a normalized level of NWC.

How is a normalized level of NWC calculated? Net working capital is defined as current assets minus current liabilities.

A normalized level of these items reflects what the business has historically needed to operate.

Certain items, therefore, need to be adjusted in the NWC calculation to reflect actual needs.

There are three main types of adjustments:

  • Definitional
  • Due Diligence
  • Pro Forma

Definitional Adjustments Typically, transactions are cash-free and debt-free, and some items are included or excluded by definition.

Here is a non-comprehensive summary of what is generally included and excluded:

Included:

  • Accounts receivable
  • Inventory
  • Certain prepaid expenses
  • Accounts payable
  • Accrued salaries and wages

Not Included:

  • Cash
  • Debt
  • Debt-like items
  • Investment accounts
  • One-time events
  • Unearned revenue
  • Accounts receivable over a certain age
  • Inventory over a certain age

Due Diligence Adjustments These adjustments often relate to non-operating or non-recurring items, or differences in accounting methods.

Conversations with management, detailed analysis of financials, and an understanding of accounting processes are crucial to uncovering these adjustments.

Pro Forma Adjustments Pro forma adjustments modify current assets or liabilities to account for recent changes in the business.

For example, if the business recently changed its payment terms with all customers from net 30 to net 45 within the last two months, an adjustment may be made to show the impact of this change over the last 12 months.

How is the peg set? In most transactions, a 12-month average is used as the peg for NWC. However, in some circumstances, a different timeframe may be more appropriate.

For instance, in a fast-growing company with rapidly increasing working capital needs, a 3-6 month average may be more suitable.

For highly seasonal businesses, you might discount or exclude less active months from the calculation.

How is NWC handled in the sale of a business? There are several ways to handle NWC in a transaction.

Here are a few options, from simplest to most complex:

Easy Option: No NWC, Adjust Purchase Price

If you're buying a small business, the seller may not understand working capital.

Instead of risking the deal by trying to explain it, you can exclude NWC from the transaction entirely.

However, you'll need to adjust the purchase price to avoid overpaying.

For example, if the enterprise value is $2 million and the business requires $500k in NWC, you’d buy the business for $1.5 million and bring your own working capital, either through contributions or a bank loan.

Medium Option: Leave Working Capital in the Form of Current Assets

If the seller is willing to leave some working capital in the deal, you can negotiate for them to include a mix of accounts receivable, inventory, and possibly cash.

In this scenario, the simpler your explanation and calculation, the better.

Hard Option: Post-Closing Adjustment Although typical in larger transactions, this approach is uncommon and generally not allowed in small business transactions funded by SBA loans.

In this case, there’s an adjustment to the purchase price at closing based on the estimated working capital.

A few months after closing, the actual closing working capital is calculated, and a true-up is completed.

What is the role of a QoE provider in the process? A quality of earnings (QoE) report plays a key role in analyzing NWC.

A good QoE provider will:

  • Summarize historical NWC to establish the peg
  • Identify periods of potential cash crunches where a line of credit may be needed
  • Make adjustments to NWC and identify any debt-like items

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