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Welcome back! In our last post on net working capital (NWC) in a transaction context, we discussed what NWC is and why it matters in a transaction. We also introduced the idea that buyers will typically expect “sufficient” NWC to be delivered on closing. In this week’s post, we will dive into how this NWC level is determined and how it impacts sales proceeds.
Up to this point we have referred to a “sufficient” level of NWC that is expected to be delivered on closing. In the world of mergers & acquisitions, this is typically referred to as “normalized” NWC – that is, the level of NWC that is “normal” for a business.
Although there are many ways to determine normalized NWC, a robust analysis will include consideration of the following:
As normalized NWC is typically determined with reference to a historical period, which cannot be changed by the time a transaction is consummated, our third key recommendation of this series is:
Manage your NWC levels carefully several years in advance of a transaction to avoid leaving money on the table due to a history of excess balances.
In addition to the above considerations, it is likely that a business’ historical NWC accounts include specific items that should be adjusted in determining normalized NWC. These are referred to as:
In determining normalized NWC, it is important to identify and remove any unusual, non-recurring and non-operating amounts from the historical balances, as well as any amounts that would be excluded from the definition of NWC in the purchase and sale agreement. Although the specific adjustments will vary from business to business, those we most frequently observe include:
Identifying NWC normalizing adjustments can be a time-consuming process, but it is generally worth the investment. Our fourth key recommendation of this series is:
Take the initiative to analyze your historical NWC levels and negotiate a normalized NWC level early in the transaction process, ideally before going exclusive with any one buyer.
This is because a vendor’s negotiating power typically falls later in a transaction process and, as mentioned, the agreed normalized NWC level will impact the sales proceeds. How does this work?
Although a full discussion of the treatment of NWC in a purchase and sale agreement is beyond the scope of this post, a fulsome agreement will typically include the following:
The NWC surplus or deficit is the difference between the NWC delivered on closing and the normalized level agreed. For example:
Over this series we have discussed what NWC is, why it matters in a transaction, how it can be determined and how it impacts the purchase price. NWC can be a complex area of a transaction and having an experienced advisor to assist with the analysis and negotiations can help immensely. If you are in the process of selling your business or are contemplating selling in the future, please reach out to one of our transaction advisors for more information.
CPA, CA, CBV
Partner - Advisory Services
Mike has over 25 years of experience providing accounting and business advisory services, with a focus on the Canadian insurance industry.
CPA, CA, CBV
Alex Wong is a partner at Smythe Advisory and is focused on being a trusted business advisor to his clients.
CPA, CA, CBV
Director of Valuation Services
Paul Woodhouse focuses on providing financial advisory and litigation support services to clients.
Gagandeep specializes in M&A advisory engagements, as well as business valuations in the contexts of management buyouts and succession planning.
Arthur’s mandate is to assist Smythe clients in Western Canada in preparing for and executing business divestitures or acquisitions.