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Working Capital
When Selling a Business
Understanding the concept of Working Capital is vital for success. The failure of sellers to understand this important concept has led to many deals falling apart, or litigation after a deal has been closed.
The Role of Working Capital
The sale price of your business includes working capital: current assets less current liabilities. Buyers want to know they are getting enough working capital to continue operations and not run into liquidity problems.
The value of working capital can vary from one date to another. For example, working capital for your most recent year end might be $500,000. At the closing date though, it might be only $200,000. Is the buyer expected to just grin and bear it? Obviously not. That’s why buyers insist on setting an exact amount up front.
The failure of sellers to understand this important concept has led to many deals falling apart, or litigation after a deal has been closed.
Working Capital Requirement
Some businesses are very seasonal and working capital levels can vary considerably. For example, the working capital of a retail business in a busy shopping mall would be much higher on December 1 (high sales; high inventory) than on February 1 (low sales; low inventory). Using December’s working capital would be unfair to the buyer, but using February’s working capital would be unfair to the seller.
Therefore, it’s usually most appropriate to calculate working capital on the last day of each month for a whole year, and then calculate the average. This will result in a value that’s fair for both buyer and seller.
“Success depends upon previous preparation, and without such preparation there is sure to be failure.” – Confucius
Special Treatment for Cash
Although cash is part of working capital, it requires special treatment because the amount of cash is controllable by the owner. For example, the owner may choose to leave excess cash in the business to defer paying personal taxes. Many businesses, in fact, have significantly more cash than the ‘normal’ amount needed.
If we were to include this excess amount of cash in the working capital calculation, the amount of working capital wouldn’t represent the amount actually required to run the business. The seller would be giving the buyer more than necessary.
The reverse could also be true. If the amount of cash is lower than the normal amount needed to run the business, the buyer is being short changed. The last thing the buyer wants is to have to inject cash into the business on takeover day.
Determining the Cash Component of Working Capital
Once you and the buyer have agreed on the amount of working capital to be included in the sale (without cash), you must then determine how much cash should be included in the working capital calculation. Basically, the business needs to have enough cash to pay expenses for a certain period of time.
The calculation of recommended working capital creates a basis of fairness to both the seller and the buyer. Because it’s a yearly average though, it doesn’t take seasonality into account. If the sale occurs at a peak period, the average may not be adequate. If the sale occurs at a slow period, the average may be too high.
Also, buyers will want to take a closer look. They may want to adjust the amount for obsolete inventory, accounts receivable that may not be collected, or other items. Therefore, the recommended working capital can be seen as a starting point for negotiations.
Working Capital Adjustment
Once you and the buyer agree on the amount of working capital, including cash, it’s important that you understand how this could affect the sale price.
Working capital will be calculated on the closing date and a mechanism to adjust for an overage or shortfall will be part of the deal. One way to adjust for any differences is by adjusting the sale price of the business.
If working capital at closing is lower than the amount agreed upon, the difference will be deducted from the sale price. If it’s higher, the difference will be paid to the seller.
