Net Working Capital Requirements

When acquiring/selling a business, it is customary for the buyer and seller to agree to a certain level of net working capital that must be delivered at the consummation of the transaction (“Closing”).  This is a necessary agreement for both parties and one that often causes confusion, so we thought it would be valuable to provide some commentary.

Barron’s Dictionary of Finance and Investment Terms (6^th Edition) defines Net Working Capital as:

Current assets [cash, accounts receivable, inventory, etc.] minus current liabilities [payroll, utilities, accounts payable, etc.].  Working capital finances the cash conversion cycle of a business – the time required to convert raw materials into finished goods, finished goods into sales, and accounts receivable into cash.  These factors vary with the type of industry and the scale of production, which varies in turn with seasonality and sales expansion and contractions…

The first time that this concept is usually discussed, is when a potential buyer delivers an Indication of Interest (“IOI”) to a seller.  Most commonly, these take a similar form (the Net Working Capital language is underlined below).

Common IOI Language:

“Based on our review of the information provided to-date by MANGAEMENT and BANKER, BUYER proposes to acquire COMPANY for a Total Enterprise Value of between $X and $Y.  The Total Enterprise Value assumes that the Company is free and clear of any liens, claims, and other encumbrances, free of any debt or non-ordinary course liabilities, and has net cash sufficient to cover the net working capital requirements of the business.”

Simply stated, when a party agrees to acquire a business, unless otherwise negotiated, that party expects to acquire a “going concern” (i.e. he/she expects to pay cash or other consideration at Closing and receive a business that can make products or perform services, collect from its customers, and pay its bills).  If a business is not delivered with enough assets to meet its liabilities, the buyer would be paying the seller for the company and the business’ creditors for liabilities to be covered (including the company’s payroll, utilities, etc.). 

For example, assume a buyer had negotiated to acquire a calculator manufacturer that took one month to produce, sell, and collect payment for its calculators.  If the buyer had agreed to pay $100 for the business, at closing, the buyer would pay the seller $100 and the seller would deliver the business.  However, if the seller did not leave enough working capital in the business to cover its liabilities, the buyer would have to put more money into the company to keep the lights on.  Until the second month (or the end of the one month, cash conversion cycle), the buyer would need to pay the company’s employees, rent expenses, utilities, suppliers, etc., which would allow the company to produce more calculators, sell them, and collect payment.

Not to further confuse matters, but in businesses with seasonality or variable cash conversion cycles, this issue becomes more complex.  For example, assume you were acquiring a Christmas tree company in January.  Like many Christmas tree companies, this one sells 95% of its products in the 4^th quarter of the year and generally receives payment for these products as they are sold (i.e. in the 4^th quarter).  If the owner had 1) received payment for all the trees that he sold during the holiday season, 2) deposited that cash into his personal bank account, and then 3) sold you the business in January, you might not be a very happy buyer because you didn’t buy a “going concern”.  If you want to have trees to sell for the next year, you will need to buy fertilizer, pay employees, pay utilities, etc. and won’t receive any cash from the business to do so until after the Christmas season.  In effect, you have paid the buyer for the business and then funded 3 quarters of expenses.  In the case of Christmas trees, the cash conversion cycle might be as long as 1 year, but in other businesses, it may be a matter of minutes.  Regardless of length or seasonality of the cash conversion cycle, a buyer and seller should discuss the level of net working capital that is required to be left in the business at Closing as part of their transaction.