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A bridge too far? Part 2



Ensure you understand the relationship between Net Cash and Net Working Capital 


Last month’s article introduced the often intriguing concept of the “equity bridge”, which represents the difference between the traditional value of the business (termed the “Enterprise Value”), and what the shareholder finally receives in value (which is termed the “Equity Value”). Typically offers for your business are provided as an “Enterprise Value” which is subject to both i) net cash/debt free (“Net Cash”) and ii) net-working capital adjustments, and it is these two categories are the key components of the equity bridge and drive the “Equity Value” the shareholders will receive in cash. Having last week discussed the Net Cash adjustment, it now leaves this second article to discuss Net-Working Capital (“NWC”) adjustments 


NWC is the difference between a company's current assets such as accounts receivable/ prepayments, any stock, and its current liabilities, such as accounts payable and accruals. Since both cash, debts and similar-type items are dealt within the previous discussed Net Cash adjustment, these components are specifically excluded from the NWC balance. 

In simplistic terms the NWC represents the cycle of funding available to a business for use in day-to-day operations, and is essentially the lifeblood of any business and enabling the business to cover day-to-day costs and continue to trade. A healthy level NWC usually indicates that the business generates income and collects its debtors efficiently, as well as managing its inventory and creditors effectively. A diagnosis of NWC is typically performed through the sum of its constituent current asset against its liability balances, and this net balance is usually referenced as a percentage of revenues whose trend is monitored. 

In reality there is no right answer to the correct NWC % a business should have since it depends on the business’s sector, scale (and therefore negotiating power) and its financial strength. Businesses who manage fixed terms for receivables and payables will generally find a consistent and predictable trend, although unexpected events such as late or early debtor payments from a material customer can still cause a temporary flux. The trend over a period of say 12-18 months will provide a good indicator of what the business requires to support its future. 


▪ The effect of a delay of a key customer paying an invoice on its due date, will see the continuance of this trade receivable within NWC inflating its value. Since the company will still require to pay its staff payroll or its own trade payables, its cash balance will therefore have a similar but opposite decrease. 


In a stable business (after discounting the effect of large cash outflows such as dividends or large capital payments), the monthly trend of NWC can be shown to be inverse to the trend of Net Cash (ie. Cash less debts). NWC is therefore effectively “Ying” to Net Cash’s “Yang”. This inverse relationship can be best demonstrated as follow : 


▪ If the key customer decided instead to pay its invoices in advance of its due date, the early removal of this balance from trade receivables would decrease the NWC value. The cash balance by comparison would be inflated due to this early customer receipt by an equal and opposite increase. 


Given the inverse relationship between NWC and Net Cash, growing business often speak of the “need to invest” in NWC, since holding higher inventory levels will often be required to drive future growth, and growth will lead to a higher level of accounts receivable balances. It is perhaps not surprising that when buyers acquire a business they are keen to ensure that the business they have acquired has a normal level of working capital within the business. It would be unfair (and indeed bordering on career suicide for the poor M&A executive) that after persuading his board to acquire the business at a premium value, the target’s NWC was insufficient for forcing an unexpected additional capital injection to support its NWC. This constant fear perhaps explains the excitement often surrounding the NWC discussions, and it is important to understand the buyer’s point of view. 


The other key reason why NWC levels are critical to a buyer relates to the Net Cash adjustment (discussed in the previous article) which is typically performed at the transaction completion date. Given the “inverse relationship” between Net Cash and NWC, the buyer requires to make sure that the NWC is at a sufficient level to avoid potentially over-stating (through a higher Net Cash) the seller’s Equity Value. The seller’s advisors will similarly be interested to ensure that if the business at completion has an inflated level of NWC, that the seller is not penalised (due to a deflated Net Cash) by lower Equity Value. 

These risks are resolved by M&A advisors first agreeing a target level of normalised NWC and then making an adjustment on completion to correct any balance which is either over or under this agreed target. An inflated NWC (suggesting by implication a lower Net Cash) would lead to the excess NWC (from the target level) being added to the Equity Value. The corollary of this is that a deficit of NWC from the target level (implying a higher Net Cash) would require a reduction to the Equity Value by this deficit. 


The above gives a simplistic overview of the basic concepts involved, since given the complexities of daily business life there are a myriad of exceptions or complications that can often make this an emotional and confrontational discussion. In all cases however, having a clear understanding of the buyer’s rationale and considering what is the equitable position using the broad principles of the equity bridge, will assist in resolving such issues and avoid a strained relationship with the buyer. Accordingly the earlier the seller identifies and discusses potential equity bridge issues with the buyer, the better and will always support a smoother negotiation. As has been discussed in earlier articles, both honesty and transparency as well as demonstrating a level of fairness will always place the seller in a strong negotiating position and can often be ultimately be more favourable in terms of the final consideration achieved. 


At Red-Swan Partners our team have extensive experience from growing and selling their own businesses, being TIC corporate’s M&A executives, as well as working with a wide range of TIC business owners to support them in the development of their own exit strategy. This wealth of relevant market experience allows us to best advise seller on identifying and preparing the equity bridge and support you to secure a premium value. 


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