Question

If a company has had net working capital levels of approximately 12% of sales over the past five years, it can be reasonably estimated that the company will continue to require that level of working capital to support future sales. Therefore, it may be appropriate to add any working capital amount in excess of 12% of sales as of the valuation date to the determined company value as excess working capital (essentially a non-operating asset). A related adjustment may be made that would reduce the company's value for deficient working capital if the company had a net working capital balance below its historical levels as of the valuation date.   

Company Z has $1.2 million of net cash flow (NCF) for simplicity purposes let's assume for the industry a valuation multiple for NCF is 4.0 so we have $4.8 million Entity Value

Working Capital of $1.5 million, of which is $500 thousand, is considered a working capital surplus and therefore is added to the purchase price.

$4.8 million Entity Value plus $500 thousand excess working capital = $5.3 Million value.

Does the excess cash represent a return on the seller's investment? From a valuation standpoint, theoretically, if we used the discounted cash flow method or capitalized cash flows method we would arrive at the same $4.8 million value, didn't we use the same cash as part of the valuation of cash flows? Is this a double-dip?

Answer 1

The treatment of net working capital (typically defined for M&A transaction purposes as all non-cash current assets less all non-debt current liabilities) is frequently a topic of debate in potential deals.

• We often perform valuations for clients involved in the potential sale or purchase of businesses and have seen buyers and sellers disagree over how net working capital figures into the purchase price.
• We have seen some sellers who believe that they should receive the value of their company based on income or market-based valuation approaches, plus also be able to retain any net working capital of the business (which in many cases is comprised primarily of uncollected accounts receivable). The issue with this approach is that the value of a company based on income or market-based valuation approaches is dependent upon the company being delivered to the buyer with a sufficient amount of net working capital to support the business as reflected by its current income.

Therefore, if a seller delivers a company with insufficient working capital (because the seller has retained these assets), then the buyer would need to fund this working capital shortfall, which would effectively increase the capital required to purchase the business. Knowledgeable buyers, however, will not pay full price for a company that will not be delivered with the level of net working capital necessary to fund operations.

A certain level of net working capital is required to support a business’ sales levels. Companies typically operate with a certain amount of accounts receivable, inventory and prepaid assets which are offset by current liabilities such as accounts payable and accrued expenses.   In certain circumstances, a company may have excess working capital as of the valuation date caused by an unusual event such as a spike in receivables. This could lead to an upward adjustment to the company’s value. A simple approach to determine whether an upward adjustment for excess working capital is appropriate is to examine the company’s historical working capital levels. But prospective sellers should be aware that buyers typically expect working capital at the closing of the transaction to be equal to the most recent twelve months average working capital (based on dollars or percentage of revenue).

If a company has had net working capital levels of approximately 12% of sales over the past five years, it can be reasonably estimated that the company will continue to require that level of working capital to support future sales. Therefore, it may be appropriate to add any working capital amount in excess of 12% of sales as of the transaction closing date to the determined company value as excess working capital (essentially a non-operating asset). A related adjustment may be made that would reduce the company’s value for insufficient working capital if the company had a net working capital balance below its historical levels as of the valuation date.   Although this may seem like an increase or decrease to the sale price, that is really not the case. Remember, cash is excluded from the calculation of net working capital so if at closing the working capital is under the target that means the business likely has more cash as of the transaction closing date which is retained by the seller. So there would be no net cash impact to the seller after accounting for this cash on the balance sheet.

As with many valuation topics there is no cookie cutter answer for how to deal with working capital targets. The important thing to remember is that net working capital balances need to be considered in any transaction and that delivering a company without sufficient net working capital will only lower its purchase price at closing. We recommend to our clients to spend time analyzing their working capital to ensure they receive maximum value at the time of sale. For instance, if a Company typically pays all of its vendor invoices well in advance of when they are due, that Company’s net working capital (net of cash) is running higher than it should be going in to a transaction. The buyers will likely look at the average of the net working capital over the prior twelve months and that will be their expectation at the closing of the sale. But if this company were to begin paying their vendor bills on time instead of paying early a year or more in advance of a sale, the seller will retain more cash when the Company is sold because its working capital target will likely be lower.

A transaction can be structured in a number of different ways that may result in a buyer assuming various different levels of the net working capital of the acquired business, but sellers need to be cognizant that this will impact the purchase price at closing. At the end of the day the seller should ultimately end up with the same value, whether that value is comprised entirely of cash or a mix of cash and retained assets.