NWC PEG in LOI?

May 09, 2022

by a searcher from Calvin College in Grand Rapids, MI, USA

How many of you are being asked to PEG Net Working Capital in your Letter of Intent v in Due Diligence? Seeing a growing trend by brokers to encourage pegging in LOI to provide greater comfort/understanding to sellers.

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Reply by an investor
from University of Pennsylvania in Charlotte, NC, USA

We seldom see the actual number in an LOI, but an agreed upon definition of NWC in an LOI in some instances is virtually a requirement to adequately define the transaction consideration. The definition might be broad or very detailed depending on the quality of accounting/financial data available, the nature of the business (as noted above, customer deposits, other deferred revenue, prepaids, what's in accrued expenses, etc.), the sophistication of the parties and the extent to which due diligence and discussion have occurred before finalizing the LOI. Generally, at minimum you need a descriptive provision such as "average net working capital of the company over the prior twelve months, calculated as current assets excluding cash less current liabilities excluding debt or debt-like items as determined in accordance with GAAP and adjusted for unusual non ordinary course items...". Depending on circumstances, you might get away with a broad statement referencing a mutually agreed-upon level of net working capital based on the company's historical NWC needs, but buyer and seller need to have an understanding of what that means and especially how the at-closing and/or post-closing NWC true-up affects the headline purchase price. Not to hijack the post, but interested to hear others' perspectives on how in-depth the NWC escrow (or other offset mechanism) terms should be in an LOI.

Reply by an intermediary
from The University of Chicago in Chicago, IL, USA

NWC PEG in LOI protects the buyer. Try to quantify $ PEG in LOI if data is available. Absent that, include the methodogy and the formula. A broker should not ask for NWC PEG w/o providing needed information. Buyer should insist on info to help determine NWC PEG.

Sometimes, seller does not have monthly data, or has inconsustent cut-offs. It is better to know these up-front.

If quality financials are not avilable after the YE financials, there are ways to achieve the same result as NWC PEG w/o identifying NWC PEG.

I teach and consult on this subject. Recently, a $40 M healthcare transaction fell apart after 12 months. The LOI said "adequate WC at Closing". The PA said "WC at Closing will be $x", and then there were 3 pages of what to do for difference between actual WC and $X. The parties decided to kill the deal after 3 mionths of back and forth to determine $X. I was engaged. Issye resolved and deal close. There was good data. Problem was WC definition of WC between the two DD firms (one of them Big 4 and the other one of th eleading DD firms in a larger metro city). The lesson: focus on WC early.

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