WORKING CAPITAL: Often Misunderstood But Always Important

Working capital is not the way many owners think about their day-to-day operating cash flow, in fact it would be quite normal if this wasn’t something you ever considered when you looked at your monthly financial reports.

However, when selling a business, Net Working Capital is a vital consideration, but sadly it’s often misunderstood, and failure to grasp its importance can derail a deal at the 11th hour. Educating yourself is crucial long before you sell your business and well worth the effort because working capital will ultimately determine how much you put in your pocket after closing.

Experienced buyers such as Private Equity (PE) firms and strategic buyers always insist upon sufficient working capital to be included in a transaction. Our advice? Always address this topic early in negotiations so that there are no unpleasant surprises before the deal is closed.

So, what is Working Capital? In short, working capital is how much money you need to have readily available to meet your current, short-term financial obligations. Think of it like the gas in your tank to make the car run.

The standard formula for working capital, also known as net working capital, is calculated by subtracting your current liabilities from current assets, as listed on your balance sheet:

Net Working Capital = Current Assets – Current Liabilities. In many cases this would translate to: A/R + Inventory – A/P and other accrued liabilities.

It’s just simple math, right? Unfortunately, it’s often not as easy as it sounds. Buyers, lenders and investors all come to the table with differing opinions on how working capital should be determined. They can also disagree about whether, or how much, working capital should be included in the purchase price.

What is a Working Capital Target? Considering the full business cycle is essential, so establishing a “target,” which is an average over a period of months, is a common approach. Quite often this is a Trailing Twelve-Month (TTM) time frame, but depending on the growth of the company, it may be more appropriate to use three or six months.

Why do we call this a “target”? Because working capital is dynamic, not static – it fluctuates from day to day. It relies on timely billing and collecting. Therefore, the buyer will perform a calculation after closing to determine what the actual working capital was on the day of closing. This calculation, called a “true up,” typically occurs between 30 and 60 days after the date of closing. Should the calculated amount end up being larger than the target included in the transaction price, the buyer will pay you the difference. If it’s less, this means the buyer paid too much and you’ll have to refund the difference to this buyer. The true up is necessary because you can’t possibly capture all the receivables and payables at the exact day of close – businesses just don’t operate that way and at no other time in your operating history have you needed to draw line in the sand about who owns this or that expense.

Follow the Scout Motto: Be Prepared. It’s vital that you know how accounts receivable, payables, cash, and any net working capital requirement will be handled. That’s why it’s essential to work with a mergers & acquisitions (M&A) advisor who will ensure that you clearly understand working capital every step of the way. Because Touchstone Advisors speaks with hundreds of business owners and potential buyers, we can provide valuable insight into how working capital should be handled in the sale of a business.

Before signing any agreements, make sure you and your advisors are on the same page. Verify that the formula for determining working capital is clearly defined in the Letter of Intent (Offer) stage. If you wait until the definitive purchase agreement is being drafted, you may discover that you and the buyer are not in agreement. The unhappy result of this misunderstanding could cost you hundreds of thousands of dollars or even jeopardize the entire deal.

This is the business you’ve devoted your life to building. The idea of evaluating your current process, making calculated changes, then implementing and tracking the results can feel like a daunting task, but don’t be put off by what appears to be an arduous challenge. Instead, make the decision to collaborate with an experienced M&A advisor who knows how to walk you through this process, maximize the value of your company and bring the sale of your business to a successful closing. You owe it to your company, and to yourself.