Purchase Price Adjustments in M&A: Net Working Capital

You are selling your company and have agreed a purchase price with the buyer. Then the buyer starts listing "adjustments" that significantly reduce your anticipated proceeds. What's happening?

This is a "technical" part of M&A that can surprise sellers if it hasn't been addressed properly. While most adjustments are straightforward (e.g. interest-bearing debt, cash, etc.), others are more tricky (e.g. NWC, bonuses, pension deficits, etc.)

For SaaS businesses, Net Working Capital adjustments are particularly important.

Here is what to watch out for:

• You will need to agree on a target NWC for the business. The target NWC is typically based on a “normalized” level of working capital. While the calculation may seem straightforward, things get more complicated when all parties involved start questioning what exactly should be counted as cash, debt, assets, and liabilities. These accounting intricacies, as it turns out, are open to negotiation.
• Also, what constitutes “normal” is different in every situation and, as with any business deal, each side will attempt to define the terms in their best interests. While a three-, six-, nine-, or 12-month historical average is often used in SaaS to estimate the ongoing needs of a business, some buyers will attempt to define it as an amount equal to a certain number of months’ operating expenses, or say it should be equal to zero altogether.
• If your business is affected by seasonal highs and lows in revenue and/or expenses, analyzing a longer time period might present a more accurate average. Alternatively, examining a shorter timeframe may be more appropriate if your business trajectory has changed dramatically (such as experiencing rapid growth) in the months leading up to the deal closing.

Identifying trends on an account-by-account basis is a crucial component of understanding the net working capital profile of a business.

There are also a handful of issues that can arise related to the treatment of specific accounts. For example, deciding how to account for deferred revenue is a common sticking point. In our view, short-term (12 months or less) deferred revenue – that is, the money you’ve collected in advance of delivering the product/service – should always be included in NWC, but buyers will sometimes try to treat this as a debt-like item. Another example is payroll liabilities. Regular payroll expenses should always be included as a liability in the NWC equation. However, accrued bonuses owed to employees should be treated as debt, as these were discretionary decisions made by the seller’s management before the change of ownership.

In any case, the target number should always take into account factors that are most relevant and applicable to the business as it exists today.

It is important to calculate/analyze NWC ahead of time with your banker and accountant, to be in a stronger negotiating position when the time comes during the M&A process.

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