Net Working Capital Pegs

Hey, it’s David!

M&A deals live or die by the details, and few are as critical (or as misunderstood) as net working capital (NWC).

Whether you're a first-time buyer or a seasoned operator, getting NWC right can mean the difference between smooth sailing and a financial headache.

Let’s dive into why it matters and how to navigate it effectively.

…Did We Forget to Fuel the Plane for Takeoff

During a layover last week, I found myself chatting with a fellow traveler; a CFO eyeing his first acquisition. As we waited for our delayed flight, he leaned over and asked, “What’s the one thing buyers mess up most during due diligence?”

Without missing a beat, I replied, “Net working capital.”

His eyebrows shot up. “I’ve heard the term a lot, but I don’t really get it. Why’s it such a big deal?”

That question stuck with me because it’s one I’ve heard countless times. Whether you’re buying a business or running one, net working capital (NWC) is a concept that can make or break a deal. Mastering it not only avoids headaches but also helps unlock hidden value.

What Is Net Working Capital (NWC)?

Think of NWC as the cash tied up in a business’s day-to-day operations. Here’s the formula:

NWC = Current Assets – Current Liabilities

• Current Assets: The money you expect to have on hand such as cash, accounts receivable, inventory, and prepaid expenses.

• Current Liabilities: The money you owe, like accounts payable, accrued expenses, and short-term debts.

A positive NWC means the business has enough cash to run smoothly.

…But a negative NWC? That’s a red flag!

It signals the company might be scrambling to meet short-term obligations.

Why NWC Matters When Buying a Business

Acquisitions can feel like high-stakes chess, and NWC is a key piece. It ensures the business operates seamlessly from day one without an emergency cash infusion.

Here’s the tricky part: buyers and sellers rarely agree on how much working capital is enough. Enter the NWC peg.

What Is an NWC Peg?

The NWC peg sets a baseline, an agreed-upon amount of working capital needed for normal operations. It’s based on historical trends and protects both sides:

• For Buyers: Without a peg, you could inherit a cash-starved business that needs immediate funding.

• For Sellers: A peg ensures you’re not penalized for seasonal dips or efficient pre-sale cash management.

At closing, the actual NWC is compared to the peg:

• NWC > Peg: The seller typically gets a bonus.

• NWC < Peg: The purchase price is adjusted down to cover the gap.

Why NWC Pegs Matter in Deals

Imagine you’re acquiring a business expecting $1M in NWC. Come closing day, it’s $500k. That’s half a million you’ll need to inject just to keep the lights on. A well-negotiated peg prevents this, aligning expectations and protecting both parties.

Something to consider: Analyze historical NWC trends, seasonality, growth, and operational shifts, before locking in a peg.

The Takeaway

Net working capital is the lifeline of any business. For buyers, a clear NWC peg ensures you’re not buying a ticking time bomb. For operators, mastering NWC means healthier cash flow and smoother growth.

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David