Cameron O’Neal

How does working capital in M&A work? It's complicated, but I'll try and explain in 2 minutes. When you make an offer to buy a business, this is normally an 'Enterprise Value.' This means your valuation assumes: - zero cash - zero debt, and - normalized working capital. The principle being that the final purchase price will be trued up $:$, based on the actuals. So what does normalized working capital mean. Imagine we are buying a business that manufactures halloween costumes. Painfully seasonal. Manufactures 12 months of the year, but makes all of its sales in one month. If you assume all inventory is sold during October on 30 day payment terms, it's month on month working capital profile might look like this: Now let’s think about what happens to Net Working Capital (NWC). NWC = (Accounts Receivable + Inventory - Payables). It grows over the course of the year, before crashing down in November. And the cycle restarts. The purchase price of this business should vary based on the point in the year when the deal completes. This is where ‘normalized working capital’ comes in. Also known as the ‘peg’. It's kinda like, the average level of working capital needed to operate the business. The peg is the level of NWC assumed in the enterprise value of the business. There is then a ‘true up’ between the actual working capital at closing date, and the peg. Back to our example: The dotted red line shows the ‘peg’ and the hard red line shows the actual NWC. A transaction that closes in September, results in the buyer paying the seller extra $ above enterprise value. Where a transaction that closes in December, the reverse is true. The seller owes the buyer. This will be calculated $:$ as the working capital that gets transferred below the peg. The start point of the peg, is normally the average NWC for the last twelve months. But in practice there is lots of nuance here, and its poorly understood. If you are a jedi in negotiating working capital in M&A, this can be worth an additional 1-3% of total value in a deal. At the very least, make sure you aren't on the wrong end of it.