Why a “Working Capital Target” is Commonly Used as part of a Purchase Price
“Net Working Capital” is one of the most confusing aspects of many deal structures – not only its definition, but also why it is used in the first place. Net Working Capital Targets are commonly established for larger transactions and are also sometimes used in the Business Brokerage marketplace. For this month’s newsletter, we would like to help both buyers and sellers understand why a Working Capital Target is often part of a Letter of Intent (and ultimately a Purchase Agreement).
“Net Working Capital” is commonly defined as Current Assets less Current Liabilities. Oftentimes, specific Current Assets and Current Liabilities are excluded from a Sale and, in turn, the Net Working Capital definition and calculation.
To explore Net Working Capital a little further, we will show an example using the closing Balance Sheet below.
In the partial Balance Sheet above, let’s assume that the buyer and seller agreed on a Net Working Capital Target of $500,000. As shown in the example, the actual Net Working Capital amount delivered at closing was $600,000. Because the seller delivered excess Net Working Capital of $100,000, the Total Purchase Price would be adjusted upward by $100,000.
Plugging in a Net Working Capital Target that needs to be delivered to the Buyer at closing accomplishes a few things. For one, it ensures that the Buyer receives a fair amount of Net Working Capital as part of their Purchase Price; after all, Buyers generally expect the business to continue to operate normally after they make an acquisition, and receiving adequate Net Working Capital gives them some assurance. Secondly, it helps ensure that the seller gets fairly paid for any excess Net Working Capital delivered at closing.
But why is the Net Working Capital Target calculated before a closing occurs? It’s calculated before closing to ensure that if the business performs abnormally well or poorly before the closing occurs, the Purchase Price can be methodically adjusted accordingly. In other words, if a business contains more Net Working Capital than was agreed upon, the seller should get rewarded for the difference. Conversely, if a business contains less Net Working Capital than was agreed upon, the buyer should receive in the difference in the form of a discounted Purchase Price.
Overall, using a Net Working Capital Target as part of a Total Purchase Price is an elegant solution to give fair protection to both sellers and buyers.
Thank you for reading Quazar Quips, a monthly newsletter discussing the Business Brokerage market for deals between $1 million and $5 million in value. Each month, Quazar Quips will keep you informed about statistics, trends, and helpful thoughts within the Business Brokerage deal space. To read past issues of Quazar Quips, please see our website here. Stay tuned for next month’s newsletter, where we will discuss “Unrealistic EBITDA Add-Backs.” If you or someone you know is thinking about selling their business, please contact Adam Webb at (763) 550-9555.
This entry was posted on Tuesday, February 28th, 2017 at 11:23 am and is filed under Uncategorized.
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