KEY ARTICLE TAKEAWAYS
Understand how working capital is calculated
Learn why buyers pay close attention to working capital
Learn how sloppy balance sheet management can result in a lower purchase price
What is working capital?
In most deals of any significant size (say, over $10 million) the buyer will be buying both the operations of the business as well as its balance sheet, with two exceptions (in smaller deals, the buyer might elect to lower the purchase price and the seller would retain all elements of working capital).
First, buyers generally will not “buy” cash on the balance sheet – unrestricted cash will be kept by the seller. Second, buyers will not assume any third-party debt – the seller will be responsible for paying any of its debt off at closing.
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This type of deal structure is referred to commonly as a “cash-free, debt-free” deal. This simply means the seller keeps the cash in the business and is responsible for paying off any third-party debt. There are some limited exceptions, as we discuss below.
When it comes to the balance sheet, fixed assets and long-term liabilities generally don’t change much from day to day. However, current assets (like inventory and accounts receivable) and current liabilities (like accounts payable, deferred revenue, and accrued expenses) can vary significantly even over the course of a month. We explain why this is important below.
So, in the context of a transaction, working capital is generally defined as current assets (not including cash) minus current liabilities (minus any current amounts of third-party debt that the seller will be paying off at closing).
Why is working capital important when selling your company?
Buyers for deals that are over $10M (and sometimes less than this) generally purchase both the operations of the business as well as its balance sheet, of which working capital is typically a significant component.
When a buyer purchases a company, the buyer expects that it will not have to invest additional amounts to finance the ordinary course of the business. As a result, the buyer expects that the business will have “adequate” working capital to continue to operate the business. This term, “adequate,” appears in almost every letter of intent we have ever negotiated.
Buyers are really trying to protect themselves from one of the following scenarios:
- Accelerating A/R Collections. This is where the seller pushes to collect as much of their outstanding accounts receivable as they can, convert it to cash, and then take that cash as part of their “cash-free, debt-free” transaction. In this scenario, the seller ends up with more cash, but the buyer no longer has the cash flows from those accounts receivable that would have been collected in the normal course and therefore must invest more capital to finance the normal operations of the business.
- Deferring A/P Payments. This is where the seller simply doesn’t pay its bills on time in the month or two preceding closing, which will increase the cash on the balance sheet (which goes to the seller), but also create a much larger accounts payable balance that the buyer will have to quickly pay down (again, requiring the buyer to invest more cash in the business).
- Deferring Inventory Purchases. This is where the seller decides for the month or two preceding closing to simply not purchase as much inventory as they might normally purchase. This again will require that the buyer invest more capital to purchase additional inventory to get the company’s inventory balance back up to a normal level.
There are of course other working capital scenarios that the buyer is seeking to protect itself against, but these illustrate the general point. Buyers don’t want sellers to decrease current assets or increase current liabilities (both of which would decrease the amount of working capital in the business) beyond what is typical.
In these situations, a decrease in working capital (defined as current assets (not including cash) minus current liabilities (not including third-party debt)) will increase the amount of cash on the balance sheet, which in most deals is the seller’s to keep. Cash increases or decreases as working capital decreases or increases. This is why buyers want to ensure the business has “adequate” working capital at closing.
So what is “adequate” working capital?
For sellers, this can be a significant problem and is often a surprise in the week or two before closing (which is usually the time at which the buyer tells the seller what they believe “adequate” working capital should be).
Let’s take an example of a company that has working capital balances that range from $1 million to $2 million during the course of a month, with a daily average balance of $1.5 million. After its diligence, the buyer might argue that the company needs to have at least $2 million in working capital because that is the “high mark” of what the business requires. If the business has $1.5 million in working capital at closing, then the seller must leave $500,000 in cash in the business. Certainly not something the seller likely anticipated.
For an unwary seller who has not addressed what “adequate” means in the letter of intent, this could end up costing them $500,000 or more (the difference between the high water mark of $2 million and the average working capital balance of $1.5 million).
Some buyers are very sophisticated in how they examine working capital, and we have seen several buyers attempt to effectively reduce the purchase price indirectly by arguing for an artificially high working capital target or “peg”. This is why sellers must understand what working capital is and how to protect themselves in a negotiation around what is “adequate” working capital.
How can you protect yourself against working capital issues?
There are several steps you should take to minimize the potential that you leave money on the table as a result of being poorly positioned when it comes to your negotiations around working capital. We are going to take these steps in the reverse order in which you would take them ahead of a transaction to make this easier to understand.
Insist on defining what “adequate” working capital is in your letter of intent. In situations where we cannot come to an agreement on the actual dollar working capital target, we ensure there is not only a formula for defining what is “adequate” working capital, but will also include an exhibit to the letter of intent that illustrates in detail how working capital will be calculated. This minimizes disagreements and disputes later in the process.
Plan ahead for what formula you are going to propose. For the formula, we typically use an average working capital balance as calculated over the last 3, 6 or 12 months. For businesses that are growing rapidly (where working capital balances are increasing quickly over time), we might lean toward using a longer time period (12 months) to reduce the working capital target, whereas for businesses that are seasonal and we expect to close during a slow period we might argue for a shorter time period to minimize the working capital target.
Prepare a detailed financial model, including balance sheet amounts, that will allow you to examine your working capital balances over time both historically and in your forecast. This will give you better insight into which formula for working capital will work best for you (i.e., which formula will minimize your working capital target). This model should exclude accounts that the buyer will not be assuming and should normalize for any account balances in specific periods that were abnormally high or low.
Manage your working capital (accounts receivable, accounts payable, inventory, etc.) aggressively in the 12-24 months prior to your expected closing (or longer, ideally). By being disciplined in your collection of outstanding accounts receivable, extending your accounts payable to the extent you are able, and tightly managing inventory, you will decrease the average working capital balances for the 3, 6, and 12 month periods prior to closing, which will benefit you in the form of additional cash at closing because you will have a lower working capital target at closing.
Need more help?
If you are still not sure how best to manage your working capital to maximize your cash at close in a transaction, please reach out to us at [email protected]. We’d be happy to help you think through your own specific situation.
In addition, if you’d like to learn more about how your working capital management might impact your company’s valuation or marketability, click on the red banner above to take our CoPilot Assessment. CoPilot will help you identify if your company has working capital gaps, in addition to other risks. CoPilot identifies over 90 different types of potential risks your company could have that will make your business less valuable in the eyes of an investor. Get the test ahead of time and build value today with CoPilot.
As an Associate at Class VI, John is responsible for deal execution and board advisory services for clients in several industries including business services, food and beverage, distribution, consumer products, and energy. John also assists in Class VI’s marketing efforts through content development.