Impact of net working capital in private capital market investments
By Brian Foltyn, REDW
In the first quarter of 2023, the U.S. economy grew more slowly than its pre-pandemic low. The banking crisis affected the stock and bond markets, and the housing market continued to slow from high interest rates. Such macroeconomic factors can affect the private and public capital markets. While the New Mexico Angels typically invest in those companies whose products and services are based in the local economy, it is important to consider how the current and future economic landscape impacts an investment’s operations and how these factors, among other things, can affect an investment’s working capital requirements.
Net working capital (“NWC”) is an essential component for any investor to consider before funding an investment in the private capital markets. NWC represents the money necessary to support a company’s (anticipated) day-to-day obligations. Since New Mexico Angels favors early-stage companies, NWC requirements need to be set at the appropriate levels to support the respective growth initiatives. For example, when an early-stage company projects ‘hockey-stick’ type growth and expansion, additional future funding may be required, which could reduce free cash flow, increase risk, and lower company valuation to reflect the required rate of return on an investment.
In general, NWC is defined as current assets less current liabilities; however, determining NWC requirements for investment purposes can sometimes be much more complex. The process can often involve:
- Definitional adjustments, such as a cash-free, debt-free calculation.
- Non-operating or nonrecurring add-back adjustments (commonly known as ‘normalizing adjustments’); and/or
- Pro forma adjustments, such as recasting historical NWC levels to reflect anticipated and go-forward balances.
NWC levels, specifically in early stage companies, can prospectively fluctuate due to a variety of factors, such as:
- Changes in customer preferences;
- Industry trends;
- Regulatory shifts;
- Technological advancements;
- Geopolitical landscape; and/or
- Macroeconomic factors, such as those mentioned above.
It should be noted that the New Mexico Angels, as well as an investment company’s management team, has very little influence over the above factors, which can ultimately have a significant impact on NWC requirements.
NWC requirements can also vary over different periods. These requirement shifts can result from a variety of reasons, such as growth and expansion or decline / contraction in business.
To properly account for an investment company’s NWC requirements, it is best practice to analyze the appropriate NWC metrics. The most common NWC metrics include:
- Days sales outstanding (DSO);
- Days payable outstanding (DPO);
- Days inventory outstanding (DIO); and
- The cash conversion cycle (CCC).
The New Mexico Angels define ‘tremendous potential’ as a company that can increase its value 3-5 times in less than 5 years. Assessing NWC levels and requirements is a critical component to evaluate those ‘tremendous potential’ companies seeking capital.
Brian Foltyn, CVA, is a principal in REDW’s Valuation & Related Financial Services Group. Brian has 27 years of professional experience in both industry and public accounting, which includes business valuation advisory services, strategic planning, dispute advisory, forensic accounting, and mergers & acquisitions.
Editor’s Note: New Mexico Angels’ members, investors and start-up owners submit occasional columns on economic development and start-up opportunities in the state. The Angels unite individual investors to pool their resources, providing seed and early stage capital to startup companies.