What Does Working Capital Threshold Mean?
The working capital threshold is a term used in the letter of intent (LOI) and stock purchase agreement (SPA) to identify how much net working capital the buyer expects as part of the net tangible assets in the transaction.
The buyer looks to substantiate the enterprise value of the target by comparing it against its net tangible assets, which would include the hard tangible assets (equipment, real estate, etc.) plus the net working capital required to sustain future revenue. Therefore, a working capital threshold is established as a minimum amount to be delivered upon closing the deal.
Net working capital is typically defined as the current assets less the current liabilities of the business. The current assets would include accounts receivable, inventories, and prepaid expenses, but exclude cash on hand. The current liabilities would include accounts payable, accrued liabilities, but exclude any operating lines of credit or the short-term portion of long-term debt.
Divestopedia Explains Working Capital Threshold
Buyers establish a working capital threshold to ensure that no additional funds need to be injected into the business to support the future sustainable revenue.
If the working capital threshold is zero, this means the net working capital would stay with the seller (the seller can collect all the pre-transaction receivables and pay off all the pre-transaction suppliers). However, this would also mean that the buyer would have to inject additional funds to support operations until some time post-transaction when the business starts collecting on its receivables and can fund its own operations.
The buyer will usually require the net working capital delivered to be audited 90 to 120 days post closing date by an external audit firm. If the actual net working capital delivered is below the threshold, the purchase price is usually adjusted downward dollar for dollar. This is why a smart buyer will insist on having a working capital holdback in place that is sufficient to cover any net working capital shortfalls. Similarly, if more net working capital is delivered than the threshold, the incremental amount stays with the acquired company, but the buyer would be obligated to pay the seller dollar for dollar for the additional working capital.