Newburg | CPA Staff Writers
David R. Natan, CPA, MST, CVA — February 14, 2022
Avoiding surprises when acquiring a company should be tantamount in the eyes of the buyer. One of the keys to a successful acquisition is the integration of the Net Working Capital Peg not only to avoid surprises but also properly plan the transition. Net Working Capital is defined as the excess of current assets over current liabilities. Ultimately it is used to measure the short-term liquidity of a business. Net Working Capital is calculated as follows:
Cash and Cash Equivalents + Accounts Receivable + Inventory + Other Current Assets
LESS: Accounts Payable + Accrued Expenses + Deferred Revenue + Other Current Liabilities
As the buyer works through the decision to acquire a company, one of the more important provisions to put in the LOI (Letter of Intent) would the requirement for adequate working capital post acquisition as agreed upon by both the buyer and seller. When the transaction gets to the APA (Asset Purchase Agreement) or SPA (Stock Purchase Agreement) stage we typically strongly recommend the use of a formal referenced exhibit that details all current assets and liabilities showing explicitly each item of adjustment or addback to arrive at the final Net Working Capital Peg. Ultimately this Net Working Capital Peg would result in a potential increase or decrease to the purchase price of the deal. At closing, if the final calculations come in lower than the Peg, this would mean a reduction in the overall purchase price. A final calculation that comes in higher would mean an increase to the purchase price. Coming to a middle ground that is enough to support ongoing operations seamlessly is the objective.
While often transactions may be approached using a cash-free and debt-free basis it is important to note that depending on the timing of the closing date or overall approach to development of the purchase price, cash or debt can be included within the equation. As a buyer, it is important that you develop a comfort level with the Peg and perform historical analysis whether they be the last six- or twelve-month trailing averages or an even more recent or shorter picture depending on the industry or seasonality. Ideally, to avoid headaches and unforeseen cash flow issues, the buyer would like the final closing net working capital to come in closer to the Peg determined. It should also be noted that the purchase agreement should allow for the buyer’s internal accounting team or external accounting firm to review and reconcile the final net working capital figure derived at closing within 60 or 90 days after close.
As the buyer, developing a comfort level with your trend analysis and making sure that you fold in this working capital component to inherent trends of the business and your 12-month forecast will go a long way to the success of your acquisition. Working collaboratively with the seller to ensure you have a very detailed definition of what makes up this Net Working Capital Peg will be a healthy exercise. We have detailed examples of some of the types of the explicit adjustments or disclosures to apply to the detailed Net Working Capital Peg exhibit:
- Level of cash to be left at close (if any)
- Explicit removal of any current debt obligations that are not applicable
- How the use of the company’s existing line of credit will be handled or excluded if the same banking relationship is maintained
- Adjustments for aged accounts receivable that may be 60 or 90 days old
- Office/building security deposits assuming the landlord will want full reissuance and is not assigning over the lease
- Tax adjustments that are exclusive to the seller such as sales tax payable or accrued state level composite taxes owed (under an Asset Purchase Agreement)
- Potential ‘undeposited funds’ that may be separately stated due to accounting software timing issues
- Interim period cutoff issues and hidden accruals. Depending on the date of your close, if before month-end there may be more exposure to errors. Items such as accrued payroll adjustments depending on the last pay-period could be significant to the transaction.
- Adjusting or earmarking aged or obsolete inventory
- Work-in-process adjustments to ensure proper allocations between buyer and seller. Quite often a percentage completion approach to the more significant jobs that overlap the close period might help clarify or avoid surprises down the road (over/under billed calculations).
- Deferred revenue adjustments or considerations. This is often a highly contested item. As the buyer you want to ensure you are not left with the remaining work and liability to perform while the seller gets the cash. Careful attention and explicit examples should be considered when dealing with customer advances or advanced collections.
- Ensure you have planned out the payroll transition properly not only with your weekly or bi-weekly pay date cut-off issues but also potential PTO accruals, accrued bonuses for employees, etc.
Determining the Net Working Capital Peg may be one of the more conceptually difficult areas to grasp within the buyer due diligence process. Spending the time upfront to understand the calculation will educate the buyer as to the innerworkings of the business while also avoiding any short-term liquidity concerns.
The Newburg | CPA’s due diligence team can help you navigate these complexities and avoid surprises relative to your acquisition. We deliver a tailored approach to all our acquisition due diligence clients. Visit www.newburg.com for more information.
Newburg CPA, a Boston-based accounting firm can assist you. Contact us if you have questions.