In M&A companies are usually acquired with a “normalised level of working capital”.

What this actually means is that sellers need to leave sufficient working capital in the business so that it can operate consistently with how it has operated in the past and the buyer doesn’t have to put more money into the business to cover any short-term cash shortfall shortly after acquisition.

The working capital position forms part of the EV to Equity Bridge and directly affects the price paid by the buyer. However, there is a huge amount of subjectivity in how you “normalise” working capital, so agreeing the working capital requirements of the company and how much needs to be left in the business is a hotly debated topic in negotiations.

What is net working capital?

Net working capital is a metric indicating a company’s ability to cover the costs of day-to-day trading (e.g. payroll, utilities, rent) with cash generated by the business. In its simplest formula:

Current assets – Current liabilities = Net working capital

The overall health and liquidity of a business is measured by net working capital. If current assets are greater than current liabilities, this means the company can meet its short-term obligations. In a wider sense, the metric also indicates whether a company’s current business practices – such as inventory management, revenue collection from customers and payments to suppliers – allow the company to generate more cash than it uses up.

When identifying items to include in the net working capital calculation, the question sellers must ask is whether the item is a recurrent one that is part of the company’s normal operational activities.

Common examples include:

Current assets

• Trade receivables (debtors): cash due in from customers from sales of products or services that hasn’t yet been received
• Inventory: product stock held by the company, work in progress, raw materials, finished goods on hand
• Prepayments: cash paid for expenses not yet due (e.g. rent paid monthly in advance)
• Accrued income / revenue: products or services that have been sold to a customer but an invoice has not yet been raised to ask for payment
• Other receivables: cash due to the company for non-trade reasons such as income tax receivable, insurance claims receivable or amounts due from employees

In an M&A context, it is important to note that the calculation of net working capital excludes cash (as classified under current assets on a company’s balance sheet), since this is considered separately in the calculation of net cash/debt.

Current liabilities

• Trade payables (creditors): cash owed to suppliers, which hasn’t yet been paid
• Accrued expenses: cash expected to be paid for an expense that isn’t yet due for payment but is expected to be incurred by the company (e.g. bonus payments, outstanding invoices from suppliers)
• Wages payable: cash amounts owed to employees but not yet paid
• Taxes payable: cash owed to HMRC or other tax authorities but not yet paid (e.g. VAT, corporation tax is typically considered debt)
• Interest payable: cash due as a result of institutional loans or other borrowings
• Provisions: cash which might be held in reserve relating to a business incident such as repairs required for the company’s offices or a customer not able to pay for goods or services
• Warranty or customer claims: cash owed to customers or other parties due to a reported issue (e.g. financial compensation for a complaint or replacement for a damaged product)
• Deferred income / revenue: cash received in advance from customers but the product or service has not yet been provided by the company
• Customer rebates or discounts: benefits due to customers as part of the normal course of business (often excluded from net working capital if one-off in nature)

These examples are not exhaustive. It is common for buyers to argue that certain current liabilities should be classed as part of the net debt calculation instead of as part of net working capital, which would reduce the price paid by the buyer, e.g. short-term borrowings such as overdrafts, credit card payments, accrued bonuses for the period prior to the acquisition. Each item is considered on a case-by-case basis.

For a SaaS business, which often has a high level of deferred income if contracts are sold annually in advance, it is important to make sure that this is treated as a working capital item rather than as a debt-like item, as this forms part of the ordinary course of business and the cost of service is typically minimal.

The total current liabilities are deducted from the total current assets to calculate net working capital, as shown in the formula above.

Normalised working capital

As the value of each of the working capital items changes daily for most companies, the sale and purchase agreement will specify a ‘target’ net working capital, which equates to a normalised level of net working capital for the company over a period.

Most commonly the target net working capital is calculated by averaging the last 6 or 12 months of historic current assets and current liabilities to level out any seasonality or fluctuations which may occur from one month to the next during the company’s recent past. Another method of calculating the target may be to take an average of the last 6 months’ historic data and look ahead 6 months in the forecast period to find a “normal” level. This alternative method can be beneficial if, for example, a company is scaling revenues quickly but with minimal costs of customer acquisition.

Both the buyer and seller will need to agree on the target net working capital, which in FirstCapital’s experience is always a point of contention when negotiating a deal as it will affect the amount of cash due to the sellers on completion.

The level of actual working capital in the business on the Locked Box date (or the date of completion if using Completion Accounts) is compared to the agreed target level of net working capital on a normalised basis. If there is a shortfall, then the difference will be deducted from the price as part of the EV to Equity Bridge, or if there is more working capital in the business than needed then the difference will be added to the price.

We recommend that the net working capital calculation is prepared and that sellers identify ‘normalisation’ adjustments as early as possible (typically in the Transaction Close phase of our SMART dealmaking process) to be in a strong position for negotiation.