A Working Definition of Working Capital is Imperative!
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So you’ve finally made the decision: You’re going to sell your business. No more breaking your back, dealing with the brutal winters and worrying about everything from personnel to accounting and more. Now is your chance to enjoy some time in the sun – or maybe take on that other challenge you’ve had your sights set on for a while.
Either way, you’ve probably heard something about the multiples being paid for businesses like yours and you have a rough idea of the fair market value you could achieve. Before you start booking your retirement cruise, though, there are a few other factors you should also be aware of to get a real sense of what your business is worth. Right at the top of that list is working capital.
If you’re not familiar with the concept of working capital, don’t let that worry you – in our experience, many sellers are unaware of what it is or how it can influence their selling price.
Fortunately, the concept itself is fairly straightforward – though do keep in mind that the exact definition can be somewhat fluid and specifics are usually agreed upon by the buyer and seller:
Working capital is your business’s opera-ng liquidity, which is simply your current assets minus your current liabilities.
- Current Assets: Cash or other items expected to be turned into cash within one year, including accounts receivable, inventory and prepaid expenses
- Current Liabilities: Debts and obligations due within one year, including accounts payable, accrued expenses, payroll obligations and current portion of debt.
To put this in layman’s terms, as a seller, you can’t just clear out all the accounts, leave all the debts and hand over the keys! Many acquisitions are structured on a cash-free, debt-free basis.
However, buyers often expect a certain amount of working capital be left in the business to meet short-term obligations and run day-to-day operations. Buyers will want to be assured that on Day 1 they are not required to invest additional money just to turn on the lights.
How do you choose a working capital target? The most common method is to calculate a 12-month historical average. With help from your accountant or advisor, you can analyze historical monthly balance sheets and determine rolling averages going back about 24 months. This is a process that SF&P Advisors has specialized in for many years. We can help you determine the highest (least favorable) and lowest (most favorable) working capital average, preparing you to negotiate properly. Keep in mind, the number you ultimately negotiate is a target that is subject to change at closing based on several factors, including things like seasonality, change in demand, change in payment terms, etc. The adjustment is called the “true up.”
But I earned that money! It’s mine! It’s important for sellers to adjust their perception of working capital and understand that a fair amount of money to run operations is one of the assets they’re selling with the business. Ask yourself, “Is my business worth the same amount if
I take away all the money it needs to run tomorrow?”
Working capital is a critical part of the transaction and it’s essential that both parties understand it and agree upon it. Typically, buyers don’t mind placing working capital language right up front, in the letter of intent. It allows sellers to be more committed to the deal before the actual impact is known. Failure to understand working capital and its implications on a transaction could result in you leaving real money on the table or even losing the deal in the 11th hour.
Our opinion is that it is best to address working capital in the initial negotiations. It’s in everyone’s best interests to have it included in the letter of intent or deal summary and detailed in the purchase and sale agreement. And if working capital is a foreign concept to you, you can probably benefit from using a trusted advisor to help navigate the complexities of the transaction and negotiate a deal that’s as favorable to you as possible.
- Steps To Take Today To Sell Your Business Tomorrow - October 16, 2018
- A Working Definition of Working Capital is Imperative! - February 18, 2016
- The Top 5 Mistakes HVAC Owners Make When Selling Their Companies - March 31, 2015
Posted In: Management
