Significance of Working Capital in M&A transactions – Tanveen Kaur

Significance of Working Capital in M&A transactions

Authored by:
Tanveen Kaur, Third year LL.B student at Campus Law Centre , University of Delhi 

Working capital is a topic that is often overlooked and misunderstood in mergers and acquisitions. The expectations of buyers and sellers are frequently at odds. As a result, it’s better to advocate addressing this issue early in the negotiation process, and certainly before signing a Letter of Intent.  The acquisition price and other terms (cash at closing, earnout, employment agreements, escrow, etc.) should be clearly stated in the letter of intent, as well as the amount of required working capital at closing that the seller will give as part of the transaction.

Working capital, also known as net current assets or NCA, is the difference between current assets (cash, accounts receivable, and so on) and current liabilities (accounts payables, accrued and deferred expenses, line of credit, current portion of long-term debt, etc.). The Target (or Required) Working Capital is important in M&A deals. Simply said, target working capital is the minimal amount of cash-free and debt-free working capital necessary at closing so that the buyer may operate the firm without having to add any further cash or debt. The closest analogue is the “gas in the tank” that any automobile buyer expects from the dealer before driving off the lot.

Many business owners are hesitant to “leave” money that they believe is rightfully theirs. Working capital, on the other hand, cannot be divorced from the firm. A buyer’s acquisition price for a “going concern” assumes that there is enough cash on the balance sheet to keep the business running for the foreseeable future.

Technically, the Equity, which includes Retained Earnings, equals Current Assets minus Current Liabilities, which is working capital, on a cash-free / debt-free balance sheet. There would be no working money left for the new owner to run the business if the seller “kept” the equity.[1]

The following are some of the advantages of conducting a net working capital analysis:

  1. Working capital can have a dollar-for-dollar impact on purchasing price, and it includes the following factors:
    • The evolution of the average working capital peg, sometimes known as “the Peg”.
    • Debt and debt-like objects are identified.
  1. Having a thorough understanding of working capital inclusions and exclusions would help to improve the definition of working capital and indebtedness in the purchase and sale agreement.
  2. Avoiding net working capital disputes, as well as the associated managerial distraction and expenses.
  3. The completeness and/or adequacy of current liabilities, as well as the quality of current assets.
  4. Cash/financing requirements for post-transaction operations[2].

When conducting an M&A deal that incorporates any element of working capital, there are a few crucial considerations to keep in mind:

  • Check to see if all of Seller’s accounting methods are in accordance with GAAP, and if not, what is the difference? This is a critical point. A GAAP standard is virtually always used to guide the reconciliation and settlement process. As a result, if you set a working capital target based on historical financial company presentations that are not in compliance with a GAAP standard and then guide reconciliation in accordance with a GAAP standard, you will inevitably encounter an unintended result that will most often negatively impact the Seller;
  • Ensure that the “Target” is calculated using all of the accounts that will be included in the Estimated and Actual Working Capital; a non-GAAP Seller may be caught off guard here if all accruals are not included in the working capital target;
  • If any working capital accounts include assets or liabilities that are influenced by affiliated or related-party connections, make sure to evaluate them during the LOI stage so that they are suitably incorporated or excluded in the deal scope and any target calculations. These could include non-operational items that need to be left out of the transaction. As a result, they should be removed from the working capital target calculation as well;
  • If the Seller has avoided reserving against uncollectible accounts, it is best to evaluate the impact of recognizing these issues at the LOI stage and possibly excluding these items from the transaction so that they do not get caught inadvertently during the reconciliation stage and reduce the purchase price. The obvious implication of recognizing an uncollectable account is that it may have an influence on previous earnings, which could be used to value a transaction, therefore careful consideration is essential;
  • Consider including an illustration of the technique utilized and the detailed working capital accounts included in the Target as an attachment or appendix to the Purchase Agreement. This is especially essential if the extent of what is included in working capital differs from GAAP standard or if the Seller’s historical accounting technique differs from GAAP standard. This is a basic yet effective strategy for reducing future disagreements;
  • A Seller is best positioned to plan ahead of time and review the various ways for defining the Target, so that the method and scope conversations can be addressed in the LOI, avoiding any confusion or disagreement later in the process. We can’t stress enough how important it is for the Seller and his or her advisors to conduct this study before discussing a LOI with a potential Buyer;
  • While not exactly a working capital problem, expenditures in capital equipment undertaken between the LOI and Closing may reduce the Seller’s net cash proceeds in a cash free/debt free transaction. This is one of the most serious disagreements that can arise between a buyer and a seller. The more money invested in capital equipment during the term of a LOI, the less money the Seller will be able to keep. This isn’t exactly what the Buyer wants, as the Buyer would like to keep investing in the capital equipment that’s needed to stay competitive. If a capital investment plan includes a big and unusual amount of capital expenditure, this should be highlighted during the LOI stage and funded, in part by the Buyer;
  • Highly seasonal enterprises with large fluctuations in working capital balances will require agreement on working capital treatment at the LOI stage. If possible, unanticipated closing delays should be anticipated in the transaction conditions so that the agreement may handle the varying seasonal closure outcomes;
  • If the working capital target calculation and transaction scope are carefully considered, the Buyer and Seller are often unconcerned with changes in these accounts and may instead concentrate on the business’s long-term viability. Transitions and transaction conversations, in our experience, can be emotional. Any effort to mitigate the negative effects of these challenges will result in a better outcome.[3]


While this isn’t an exhaustive list of best practises and factors to consider, it’s an excellent place to start. As you might guess, many of these can be inverted and used to the buyer’s advantage in an M&A deal to increase the amount of required working capital.



[1] What role does working capital play in M&A transactions?

[2] Importance of net working capital in M&A

[3] Working capital in Merger and Acquisition transactions


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