Written by Andrew Rice, CPA, CVA, Managing Director of Trout CPA’s Transaction Advisory Services
If there’s one M&A topic that continually rears its head, causing confusion (at best) and consternation (at worst), it’s net working capital (NWC).
At its core, NWC should equate to the amount of liquidity a business needs to operate. In most transactions, cash is not acquired by a buyer. As a result, buyers need to analyze the cash generating components of a target’s cash conversion cycle, which are impacted by current assets and current liabilities, such as accounts receivable, inventory, prepaid expenses, accounts payable, and accrued expenses. The outcome of this analysis is to quantify the NWC target (or peg) to be delivered by the seller. Commonly, the NWC target is heavily dependent on historical averages during the trailing-twelve months, as this frequently corresponds with the purchase price valuation. While it seems simple enough, a bevy of practical considerations makes this exercise challenging. This can include factors such as seasonality and industry norms, as well as more fundamental concerns surrounding the exact components to be included in the definition of net working capital.
Most recently, Trout CPA was advising on a transaction that involved a target company with significant raw materials in inventory. Specifically, the raw materials were comprised of various types of metals. Due to the commodity nature of this inventory, there was intrinsic price exposure driven by the state of the metals market at any point in time. Inventory was, by far, the most significant component of NWC for the target.
The challenge: the most recent 12 months saw drastic swings in the metals market and, consequently, the level of inventory on the balance sheet. As a result, determining the normalized level of NWC was a real challenge for the buyer and seller to agree upon.
The solution: our team took an atypical approach, as far as what’s customary on most deals. We decided that what really mattered was the pounds in inventory and the composition of those pounds - not the dollars. Inventory valuation was subject to unpredictable commodity exposure. In this instance, using a typical NWC mechanism, one party would have enjoyed an economic windfall while the other would have been unfairly penalized. However, when we removed dollars from the equation, we were able to hone in on the appropriate level of pounds needed to run the business. As it was, the level and composition of pounds held by the target were consistent during the year. The only variable was the price. Accordingly, we isolated a separate NWC mechanism for inventory based on a target level of pounds (by metal) to be delivered at closing. Any over/under delivery at closing would be adjusted based on the spot rate at closing.
The reaction: while there was some initial pushback from the counterparty because this approach wasn’t traditional, our team worked diligently to ensure everyone understood the mechanics. In the end, both buyer and seller agreed that our proposal was logical and preserved the intent of establishing a fair NWC target.
It can be easy to follow the customary way of doing things when executing a transaction. However, sometimes it is prudent to take a step back and ask whether the end result is appropriate. If you are engaged in an M&A transaction, ensure that your advisors have the technical expertise and experience to provide thoughtful guidance. Trout CPA’s Transaction Advisory Services team is comprised of seasoned professionals eager to provide the best outcomes to our clients.
