By Andrea Harris & Brendan Potts, Buckberger Baerg & Partners LLP
You built a successful business. You ground through negotiations with the purchaser. You agreed to a signed purchase agreement and sold your business. Retirement, traveling the world, and the next phase of your life are waiting on the other side. Then the final payments start coming in. But there’s a problem – the purchaser is refusing to pay the payables that were booked at year-end. And they are disputing the amount of inventory you left behind. You thought you had a deal, but now it’s being derailed and the cash you need to retire might not be coming.
Working capital disagreements can derail a deal and can become an unwelcome contentious issue even subsequent to a deal closing. This chapter focuses on working capital and how to set yourself up for a successful sale.
What Is Working Capital?
In accounting terms, working capital is the amount by which current assets exceed current liabilities.
Current assets can include:
- Accounts receivable
- Prepaid expenses
- Other current assets
Current liabilities can include:
- Accounts payable
- Accrued liabilities (such as payroll liabilities, vacation payable, and other accruals)
- Deferred revenue
- Other payables
Cash and bank indebtedness or a line of credit can be treated either as part of working capital or part of debt. In addition, income taxes payable may or may not form part of working capital. As such, your sale and purchase agreements should specify the definition of working capital. Ensuring both parties and their accountants, lawyers, and advisors understand the definition of working capital is an important step in avoiding disagreements when calculating post-closing working capital.
How Does Working Capital Affect Price?
In theory, when the company’s fair market value has been determined using a cash flow methodology, the value of the business includes an optimal net working capital amount in the fair market value. In practice, when a price is determined, the seller and purchaser might assume a set amount of net working capital is included in the price. In an ideal or notional scenario, on the date of transaction the working capital would be equal to the optimal net working capital and the price would accurately factor this in.
However, in practice, businesses operate with either excess working capital or a working capital deficiency or may operate in a seasonal industry where working capital fluctuates throughout the year. As such, on the date of the transaction, if there is excess working capital that benefits the purchaser, the vendor would expect to be compensated for that excess amount; the mechanism to do that is to increase the price. Alternatively, if the working capital is deficient and the purchaser must inject more working capital to operate the business, then the purchaser would expect the vendor to compensate them for this deficiency, which would decrease the purchase price.
Think of working capital in the context of a convenience store. Would you pay more for a convenience store with stocked shelves and extra boxes of supplies in the storage room or a convenience store with an empty storage room and barren shelves? At the time of sale, if there’s extra or excess working capital, the price will increase; if working capital is deficient, then the price will decrease.
How Do I Determine Optimal Working Capital?
Chartered Business Valuators (CBVs) use various ratios and industry metrics based on empirical data from several databases. Most of these databases require a subscription to access information, categorized by industry and for a specific period of time. Common metrics used to determine “optimal” working capital include: Current Ratio.
The current ratio is calculated as current assets divided by current liabilities. If the ratio is greater than 1, the business has enough current assets to satisfy its current liabilities. If the ratio is less than 1, the current assets are less than the current liabilities. Depending on the industry, an optimal current ratio can fluctuate. For example, a business with substantial inventory without the ability to leverage the inventory could require a current ratio of 1.5 to 2.0, whereas in other industries a current ratio of 1.25 could be optimal. Therefore, it is important to understand the specific needs of the business being purchased and its industry.
Net Working Capital as a Percentage of Sales
This metric is tracked by industry and company size and is calculated using the formula [Net working capital (Current assets – current liabilities)] / [Annual sales]. This metric determines optimal working capital based on what is required at the sale and to value a business where revenues are increasing and working capital injections are required as revenues grow. Use industry data to calculate what the industry would expect for this ratio compared to what the business has. The difference would be the excess or deficient amount.
Trailing 12-month (TTM) Net Working Capital
This metric uses the target business’s historical working capital and assumes it is the required optimal working capital. In market transactions, this methodology is common and highlights the importance of having accurate, up-to-date monthly internal financial information in the years leading up to a sale. If a purchaser calculates your historical working capital as higher than what you think you need to run the business, it can be difficult to convince them you could run it leaner than what you have done historically. Also consider the usability and accuracy of your internal statements:
- Is your inventory accurately tracked monthly? How do you track your work in process?
- Are your accruals updated monthly, including payroll accruals?
- Is your accounts receivable listing current and net of doubtful accounts?
- Are prepaids tracked monthly?
In practice, a CBV will use various resources to determine the most reasonable amount of required working capital and will then apply their professional judgment to determine what that should be. Then, the difference between the calculated optimal, ”target” or ”required” net working capital and the actual net working capital is the working capital deficiency or excess working capital. Here is an example:
200,000 Accounts receivable
250,000 Accounts payable and accrued liabilities
125,000 Deferred revenue
Annual sales = $1,000,000
The ratios would be calculated as follows:
Net working capital = (200,000 + 350,000 + 25,000) – (250,000 + 125,000) = 200,000
Current ratio = Current assets / Current liabilities = (200,000 + 350,000 + 25,000) / (250,000 +125,000) = 575,000 / 375,000 = 1.53
Net working capital as a percentage of sales = (200,000 + 350,000 + 25,000) – (250,000 + 125,000) / 1,000,000 = 20%
If the industry metrics determine that an optimal working capital is $250,000 for this business, then the difference ($200,000 actual working capital less $250,000 target working capital) would mean the company has a $50,000 working capital deficiency. In a sale, if the working capital target was $250,000, and only $200,000 was delivered on sale, then the vendor must repay the $50,000 working capital shortfall.
How Will Working Capital Be Dealt with Through the Business Transaction Process?
Through the transaction process, the purchaser and seller determine the target working capital amount. Why is it called a target? Working capital isn’t static – it fluctuates day to day. Therefore, upon closing of the transaction, time is given to calculate the actual working capital at the closing date. The difference between the target working capital and the actual working capital is paid to the seller or the purchaser, depending on whether it’s in excess or deficient.
Set the target working capital, as well as a definition of what working capital includes, within the original Letter of Intent. This is when either party will have the most negotiating power. Due to the significance of the target working capital on the cash that ends up in the vendor’s pocket at the end of the process, negotiate this amount from the start, as well as conversations about the overall price of the transaction. In a perfect world, everything is clearly communicated and outlined from the beginning. In practice, disputes about working capital are common in the transaction process. Some common areas of dispute that can derail a transaction, as well as remedies to limit their chances of happening, are as follows:
Value of target working capital: Ensure amount is included in the Letter of Intent, or on paper through other negotiations. Expectations between the buyer and seller can be aligned.
Inclusion of working capital altogether: Some transactions do not include working capital, assuming the purchaser will supply the working capital to continue the operations post-transaction. Both parties will want this outlined within the Letter of Intent.
Whether or not cash/debt is included within target working capital: Define what accounts will be included within the targeted working calculation in the Letter of Intent.
Inventory valuation method and timing: Define how inventory will be valued, who will value it, when it will be valued, and a pre-determined method of mediating potential disagreements.
Collectability of accounts receivables: Define at what age a receivable will no longer be included, and what happens to those receivables.
Timing of true-up of working capital: Disputes can arise post-close as to when actual working capital is adjusted to the target amount. If working capital is deficient, the purchaser might not have sufficient capital to fund the working capital prior to it being “trued-up.” A holdback can be included in the purchase until after the working capital is trued up. This provides the purchaser with more financial flexibility.
Cutoff of receivables and payables: Define within the Letter of Intent how cutoff for accounting purposes will be determined.
Subsequent events affecting working capital: Outline how these occurrences will be dealt with in the Letter of Intent to help mitigate disputes. Other options include extended holdback periods on a portion of the purchase price in case such an item takes place.
Due to the types of disputes that can arise relating to working capital throughout the transaction process, contact an advisor or CBV to get ahead of these disputes early in the process and limit the risk of a transaction derailing later in the process.
How Do I Manage Working Capital Before Selling My Business?
A purchaser will typically use historical working capital amounts to determine their target working capital. If the vendor needed X amount of working capital to operate the business historically, they should need at least X amount of working capital to continue operations.
Due to this reliance on historical working capital, limit the excess working capital within the company in the leadup to the sale. Potential purchasers will analyze working capital at the date of the sale, as well as a year or two in the past. For this reason, operate as lean as possible to prove to potential purchasers the working capital is sufficient to operate the business as minimally as possible. When operating lean with working capital, the following strategies may help to reduce the working capital within your business and not affect company operations
- Strip excess cash into a holding company
- Invoice work in progress more regularly
- Provide incentives for receivables being paid early (2/10 net 30)
- Use a line of credit to carry inventory and receivables
- Extend payment on payables
Since the price of the business is constant, reducing the target working capital leads to extra money in the vendor’s pocket. If you are thinking of selling your business in the next few years, talk to a CBV about how to change the management of your working capital to benefit you in the transaction process.