In 2025, we plan to highlight certain key aspects of the transaction process in our quarterly update. In this issue, we focus on the importance of working capital targets in middle market transactions.
In middle market transactions, some of the most crucial points of negotiation are the net working capital targets agreed upon by the buyer and seller. Net working capital targets set a defined minimum amount of working capital that the buyer requires the seller to leave in the business at the close of a transaction.
Given that net working capital targets can have a direct effect on the final purchase price of a transaction, understanding the how and why of these types of negotiations is crucial for buyers looking to negotiate deals that not only look good at closing but also pass the test as the buyer takes over the operation of the newly acquired business.
Defining Net Working Capital
By the book, net working capital is defined as current assets less current liabilities. While this definition is acceptable for financial statement analysis and other accounting-adjacent applications, in the M&A universe, the most commonly used measure of net working capital is cash-free, debt-free net working capital. This is the standard definition of net working capital in a deal setting because it assumes that a seller will retain the cash in the business after paying off any short-term debts that the business owes. These debts could potentially include related party notes and lines of credit with banks.
In an M&A transaction, net working capital and net working capital targets are often defined terms in both the letter of intent and the purchase agreement. For buyers, it is crucial to understand these definitions because the basis of the net working capital calculation could directly affect the final purchase price.
Why Are Net Working Capital Negotiations Necessary in a Deal?
Net working capital targets are necessary in deal settings because the amount of net working capital in a business often fluctuates from month-to-month and even week-to-week. Therefore, it is important that a benchmark or base level of net working capital to be left in the business at closing is agreed upon by both the buyer and the seller. If net working capital levels at closing are not in line with the targets established in the negotiation process, an adjustment to the purchase price can be triggered.
Negotiating Net Working Capital Targets
The most practical and commonly used method of setting net working capital targets and benchmarks is to calculate a historical average amount of net working capital needed to fund a company’s operations. This is most often done by calculating the average net working capital on a monthly basis over the twelve months preceding the valuation date used in the transaction.
While conducting due diligence, buyers may find potential adjustments to certain balance sheet items that comprise net working capital, which can affect the calculation of the net working capital target. Buyers will want to confirm that the seller has properly accrued (both historically and at closing) for certain items such as accrued vacation, payroll, bonuses, warranty obligations, etc. These potential adjustments can add another layer of complexity to the negotiation of net working capital targets, as buyers may find that there is an excess or deficiency of net working capital at certain points in the historical lookback period.
Sellers will often make the argument that they have historically operated with excess working capital based on comparisons to industry averages. It can be difficult to convince the buyer of this excess working capital argument absent compelling evidence. With further analysis, there is often an explanation as to why the historical level of working capital has been carried on the company’s balance sheet. The question as to whether this level is excess or not is up for negotiation.
Concluding Thoughts
Having a team of seasoned advisors to assist with the acquisition and due diligence process can ensure buyers that the net working capital targets, and thus the purchase price, are set at levels that are appropriate and fair to the buyer.
Since 1982, Mercer Capital has offered M&A advisory services to a diverse range of public and private companies, leveraging extensive valuation and investment banking experience to guide clients through complex transactions. While our team provides objective advice, we also advocate for our clients while navigating the competitive marketplace of private equity groups, family offices, and strategic buyers. We facilitate informed decision-making with a tailored, multi-phased approach to planning and executing transactions. For confidential consultation on your transaction-related needs, contact us today.
Originally appeared in Mercer Capital's Middle Market Transaction Update Newsletter: Spring 2025