Understanding the Importance of a Net Working Capital Peg in Deal Negotiations
1. What is a Net Working Capital Peg?
Understanding the Target company’s normalized net working capital in the context of a Merger & Acquisition transaction (“M&A”) is crucial. A Net Working Capital (“NWC”) peg is the threshold/ baseline amount of the Target company’s working capital that is mutually agreed upon by both the Buyer and Seller.
A common way to assess the NWC peg is to take the average of the last 12 months of Target company’s NWC, subject to normalization financial due diligence adjustments. The extent of the review period required hinges on understanding the business cycle of the Target company.
Establishing a NWC peg in deal negotiations essentially translates to putting in place a potential purchase price adjustment to ensure that the Target company has an appropriate level of NWC at completion of the M&A transaction.
2. Timing of the Deal Process
A M&A transaction is usually a long-drawn process that includes many different stages, ranging from the: (1) term sheet stage; to (2) due diligence stage; to (3) signing of sales and purchase agreement (“SPA”); and finally (4) deal completion.
Deal Process
In most transactions, there will be a period of uncertainty between signing of the SPA and completion of the deal as both the Buyer and the Seller are required to obtain regulatory approvals. During this period, working capital numbers are likely to fluctuate due to market conditions or changes in payment terms and this fluctuation in Target company’s NWC can be potentially beneficial or detrimental to the Buyer or Seller. This uncertainty can be mitigated by establishing a NWC peg.
In most transactions, there will be a period of uncertainty between signing of the SPA and completion of the deal as both the Buyer and the Seller are required to obtain regulatory approvals. During this period, working capital numbers are likely to fluctuate due to market conditions or changes in payment terms and this fluctuation in Target company’s NWC can be potentially beneficial or detrimental to the Buyer or Seller. This uncertainty can be mitigated by establishing a NWC peg.
3. Fair and Equitable to both Buyer and Seller
The agreed upon NWC peg is a fair and neutral value that reflects the true working capital needs of the Target’s business.
Once the NWC peg is set, there is a dollar-for-dollar adjustment at the time of closing for any difference between the actual NWC of Target company as at completion and the NWC peg. Please see table below for further illustration.
- Scenario 1: If the Target company’s actual NWC as at completion is lower the NWC peg on the day of deal completion, the Buyer will pay a lower dollar-for-dollar amount for the difference. Hence, effectively decreasing the purchase amount.
- Scenario 2: If the Target company’s actual NWC as at completion is above the NWC peg on the day of deal completion, the Seller will receive a higher dollar-for-dollar amount for the difference. Hence, effectively increasing the purchase amount.
The implementation of a NWC peg is to protect both the Buyer and Seller in the M&A transaction.
4. Safeguard Buyers from Unexpected NWC fluctuations
A NWC peg acts as a safeguard to ensure a sufficient level of working capital is retained in the business after the completion of the deal.
In the event of NWC fluctuations (as illustrated in the chart below), there is a need to understand and assess if the new lower level of NWC is representative of an optimal level of NWC at completion.
5. Definition of NWC can be Customised
The most common definition of NWC is current assets less current liabilities. However, depending on the target company’s way of business, the definition of NWC can be expanded accordingly. Below are some examples of balance sheet items can be excluded/ included in NWC:
- Cash: Cash can be excluded if the M&A transaction is structured on a cash free and debt free basis.
- Tax related provisions and accruals: Nature of tax related balances will have to be studied to assess if it should be categorised as NWC.
- Current portion of bank borrowings: This balance may be excluded from NWC and categorised as a debt-like item.
- Exclusion of selected balances in NWC may also include:
- Obsolete inventory balances;
- Accounts receivable balances overly exceeding normal credit terms granted to customers; and
- Disputed accounts payable balances.