Why is a Working Capital Calculation Critical in Selling our Business?

Business CompanionMany business owners assume the purchase price for their business will be based on a multiple of some financial metric (earnings, EBITDA, revenue, etc.). This is generally true, but it might not be the only factor in calculating the purchase price. A buyer may also require a specific or minimum amount of “working capital” on the balance sheet when they buy it to ensure there are no immediate liquidity issues. To do this, the seller generally agrees the business will have at least or exactly $X of working capital on the date the sale is completed. Easy enough, right? Not necessarily. How working capital is calculated can be complicated and can result in unexpected downward adjustments to the final purchase price that reduces the seller’s proceeds. Below are some items to consider for calculating working capital when determining a purchase price of a business.

  1.  What is working capital, gross working capital and net working capital?
    You’ll often find these terms are used interchangeably, so you must be clear as to what you’re trying to define. Technically, both “gross working capital” and “working capital” are defined as total current assets. “Net working capital” is defined as current assets minus current liabilities. More often than not, “working capital” is used interchangeably with “net working capital.” The concept of “gross working capital” is not common when determining a purchase price adjustment as it doesn’t take into account liabilities the buyer will be assuming. Before you begin negotiations, make sure both buyer and seller agree on which definition of working capital you will be starting with. For our discussion, we’ll use “working capital” to represent current assets minus current liabilities.
  1.  What is so difficult about “current assets minus current liabilities?”
    Many business owners assume they can look at what is recorded on their balance sheet in current assets and current liabilities and be done. Not so fast. While the definition of working capital seems straight forward, what will be included in the calculation of working capital can be a major negotiating point for buyers. A buyer may want to exclude liabilities related to past performance (bonuses or accrued vacation) or prepaid assets directly related to the transaction that will not convert to cash in the future. The buyer may also want to make adjustments to working capital for obsolete inventory or uncollectible receivables that have not been properly reserved. Based on the specifics of the business, there could be a number of adjustments the buyer wants to make when using working capital as a component of the purchase price. These adjustments result in “adjusted working capital.” This term may be used in the purchase and sale agreement, or “working capital” could continue to be used with the definition including all of the adjustments discussed above.
  1.  When should the working capital calculation be determined?
    To avoid surprises at closing, the seller and buyer should negotiate the definition of “adjusted” working capital as early in the process as possible. How it will be calculated should be clearly stated in the purchase and sale agreement. If done correctly, this can sometimes be a lengthy calculation and is often included as an appendix. Be as detailed as possible describing each exclusion or adjustment to avoid disagreements at closing.
  1.  How is working capital used in calculating a purchase price?
    There are several ways to use working capital as a factor in calculating a purchase price. Below are a couple of examples.

    Minimum working capital requirement – the seller agrees to deliver a minimum amount of “adjusted” working capital on the balance sheet at closing. If the actual amount at closing is above the minimum, there is no adjustment. If it is less than the minimum, the purchase price is reduced by the shortfall. This method favors the buyer since there is no possibility the purchase price will increase.

    Dollar-for-dollar working capital adjustment – the seller agrees to a deliver a specific amount of “adjusted” working capital on the balance sheet on the date of closing. The purchase price is increased for any excess of working capital at closing over the agreed-upon amount or decreased for any shortfall. This method could favor the seller as there is a possibility the purchase price would be increased at closing.

 

Regardless of what method is used to determine the purchase price, sellers should make sure they understand how the working capital calculation could impact their sales proceeds. All parties involved (buyer, seller, and their advisors) should have a clear understanding of how working capital will be calculated and document the detailed calculation in the purchase and sale agreement.

 

April 23, 2014
By Tensie Homan