What You Need To Know About Working Capital When Selling Your Business
Working capital is a key factor to focus on during your sale. Unfortunately, it is often misunderstood by buyers, sellers, and even their professional advisors. Even worse, it’s often not addressed until the very last minute.
Since working capital will influence your asking price, how your business is marketed, and ultimately how much you put in your pocket upon closing, it’s well worth taking the time to educate yourself upfront.
Potential buyers need to be sure they have enough working capital to operate your business. And, since insufficient working capital is one of the primary reasons for business failure, you can certainly bet their lender and/or investors are going to be involved and take an active interest.
Each year, MidStreet speaks with hundreds of business owners and potential buyers to provide insight into how working capital should be handled in the sale of a business.
In this article, we’ll cover what working capital is, how it’s handled by lenders, and if it should be included in the sales price you receive when selling your business.
Let’s jump in.
What Is Working Capital?
In short, working capital is how much money you have readily available to meet your current, short-term financial obligations.
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
Your current assets include anything your business owns that can easily be turned into cash within one year or one business cycle, whichever is less. This typically includes cash, accounts receivable, and inventory (both raw materials and finished goods).
Current liabilities are the debts and expenses you expect to pay within a year or one business cycle, whichever is less. This will include accounts payable (rent, utilities, payments to vendors, etc.), wages, taxes payable, and the current portion of any long-term debt (interest and principal payments).
Seems easy, right? Unfortunately, it’s often not as easy as it sounds. Buyers, lenders and investors have differing views on how working capital should be determined. There can also be disagreement as to whether, or how much, working capital should be included in the purchase price.
Is Working Capital Included in the Price?
Depending on the type of buyer and size of your business, working capital is typically handled one of two ways.
1. Smaller Deals
Often, smaller businesses are sold with no working capital other than the inventory. The buyer does not receive cash or accounts receivable. They also don't assume any of of the payables.
You get to keep and collect your accounts receivable and retain the cash in your bank accounts.
Chances are, working capital (other than inventory) won’t be included in the purchase price if:
- Your revenues are less than $5 million
- Your business was valued using SDE as the valuation metric
- The buyer is an individual
- The business is being purchased with an SBA loan
So where does the buyer get working capital? The new owner will either need to have enough cash reserves or have their lender fund the working capital needs of the business.
“SBA lenders are required to ensure buyers have sufficient funds to operate the business. They will provide working capital as part of the loan and may even offer additional lines of credit.”
Steve Mariani, President
Diamond Financial Services
If incorporated into the loan, they will work with you and their lender to estimate their working capital needs. The funds are received at closing when they are deposited into the buyer’s operating account. To offer additional flexibility, the lender may also assist the buyer by providing a line of credit.
2. Larger Deals
For larger deals, buyers will be expecting you to deliver the company with enough working capital to operate the business. As transaction sizes increase over $5 million, companies are commonly sold with enough working capital (including cash, AR, AP, inventory, etc.) to continue to operate the business. Think of it as having to sell your car with “gas in the tank”.
Chances are, working capital will be included in the purchase price if:
- Your revenues are greater than $5 million in revenue
- EBITDA was used as your valuation metric
- The buyer is a private equity firm, strategic investor, or search fund
You’ll be expected to work with the buyer to establish a base working capital by averaging daily working capital over an extended period of time, usually between three and six months. This base working capital represents the dollar amount that is included in the transaction price and is called the “target.”
The reason it’s called a target? Your working capital isn’t static – it fluctuates from day to day.
So, after closing, the buyer will perform a calculation to determine what the actual working capital was on the day of closing. This typically occurs between 30 and 60 days after the date of closing.
If the calculated amount ends up being more than the target that was included in the transaction price, the buyer will pay you the difference. If it was less, the buyer essentially paid too much and you’ll have to refund the buyer the difference. This calculation and associated adjustment is called the “true-up.”
Why Working Capital Matters
Depending on the type of buyer and size of your business, working capital can be handled very differently. And how it’s handled can make a dramatic difference in the amount you actually put in your pocket at closing.
If you don’t address working capital upfront, your total transaction value has not been clearly defined.
Work with your broker or merger and acquisition advisor to ensure you clearly understand how accounts receivable, payables, cash, and any net working capital requirement will be handled. Does the price stated in your business valuation include working capital? Before signing a listing agreement, make sure you and your advisor are on the same page.
MIDSTREET TIPDiscuss how working capital will be handled with your business broker or M&A advisor prior to signing a listing agreement. Without addressing working capital upfront, the total transaction value has not been clearly defined.
When negotiating with a potential buyer, it’s a good idea to make sure the plan for determining working capital is clearly defined at the Letter of Intent (Offer) stage. At this point, you’ll have the most negotiating power.
MIDSTREET TIPMake sure the formula for determining working capital is clearly defined in the Letter of Intent (Offer) stage.
If you hold off until the definitive purchase agreement is being drafted, you may find that you and the buyer are not in agreement. This can end up costing tens of thousands of dollars or jeopardizing the entire deal.
Define Working Capital in Your Business Sale
How working capital is handled during the sales process can have a big impact on the amount of money you put in your pocket after the sale of your business. Take the time to work with your CPA and business broker or M&A advisor to make sure you have a firm grasp on the subject early in the process.
If you want to find out all there is to know about the costs of selling your business, read our article “How Much Does it Cost to Sell Your Business?” Learning about the costs associated with a business sale will help you learn how to maximize your profit.
If you are planning on selling your business and want to gain a better understanding of the costs, feel free to give us a call today.