How Does Working Capital Factor into the Purchase or Sale of a Business?

As a buyer, you are excited about the opportunity to purchase a business and confident you have enough money for its purchase. But do you have enough money to keep it “working?” If you plan to grow the business, do you have enough working capital to fund its growth? Growing businesses require more of it than shrinking businesses as receivables are growing.

As a seller, you want to ensure that the buyer can successfully fund the operation of the business you’re putting into their hands. You want them to succeed, but not at your cost.

So the questions I want to answer in this post about working capital are:

  • How much working capital will you need? How can you ensure a supply?
  • Is the working capital included in the purchase price? Should it be?
  • If working capital is not included, where do you get it?

How much working capital will you need?

There are many approaches to calculating how much working capital a business needs. Here are two of the most common.

The simple formula—the approach we can fall into the trap of using— is:

Working Capital = (Current Assets-Current Liabilities).

This formula is not practical for most businesses. Current assets (cash, receivables, prepaid expenses, inventory, etc.) and current liabilities (accounts payable, deferred revenue, line of credit, tax payable, credit cards payable, salaries and bonuses payable, etc.,) all fluctuate through the year and the more seasonal the business the more they fluctuate.

An example: if the year-end of a retail store is the calendar year end and their sales in November and December represent 50% of their annual sales, looking at their year-end balance sheet will not tell you how much working capital is required to operate the business. At their year-end, inventory is at its lowest, cash is at its highest and payables are low.

Some forecast based on a worst case scenario. Business owners need sufficient working capital to cover their “worst case,” which they find by reviewing the monthly balance sheets of the trailing 12 months then modify based upon the working capital ratio to sales and the sales forecast for the coming year.

Whichever approach you take will only approximate what may be required as customers may pay faster or slower next year because of economic conditions or your collection process.

The cost of running out of working capital is disaster. You can go broke because sales and receivables have grown beyond your capacity to fund them or because sales have trailed off and you have not been able to adjust fixed costs and purchases fast enough.

How to cover a shortfall

You may need to pay your payables more slowly, defer salaries and bonuses and pay or withhold dividends.

A better solution is to have established a line of credit (LOC) secured by receivables and inventory that combined with the cash you keep in the business is MORE than your very highest calculation of possible need. You do not have to draw down the LOC unless you need it and the cost of having it available is minor.

Pre-arranging more financing than you anticipate needing in your business is insurance you should not be without. TWEET THIS

Is working capital included in the purchase or sale of a business?

While it is not included in most small business sales, the average level of inventory is.

The typical transaction is based upon a current accounts balance of zero* with the exception of inventory, which is treated separately.

That is: *(cash + receivables + prepaid expenses) – (payables + deferred revenue + assumed debt) = zero.

The purchase price usually includes the average level of inventory carried by the business; the price is then adjusted up or down based upon the actual inventory at closing.

This formula is used for most transactions under $2 million. There are exceptions — as I have done when the amount of working capital required exceeds what can be financed, as is the case with professional service businesses where there is no inventory and clients are traditionally slow to pay.

Most banks insist the receivables used to secure a LOC be current (zero to 90 days), but if your average receivables are 90 days this does not allow for a sufficient LOC. In this case, I would include 50% of the receivables in the transaction price, which may be funded by cash, a seller note, and term financing and then the other 50% of receivables can be funded through a LOC.

In larger transactions the purchaser typically expects to purchase a going concern with all that is necessary to continue generating the cash flow upon which the purchase price was based. That includes sufficient working capital to operate the business at its current levels. If they grow the business and additional working capital is required they will provide it.

At Sunbelt we use a methodology that generally bridges the gap in calculations done by the buyer and the seller and is the accepted practice within experienced, professional M&A firms; however, all aspects of a transaction are negotiable. The $2 million break point for inclusion or exclusion relates more to the nature of the purchaser than the dollar amount of the transaction.

Some recent examples:

  • I sold a manufacturing firm for $2 million+ and included inventory but no other working capital in the transaction as the selling price did not warrant inclusion.
  • I sold a professional services company for less than one million but included half of the working capital as I knew that if not done this way the purchaser would have difficulty in securing sufficient working capital as the clients in this industry are generally slow to pay.

Calculating sufficient working capital can be contentious

I recently had a transaction fall apart over working capital. The seller, who had purchased the business for less than $2 million (without working capital) some years ago, was now ready to retire. I marketed the business and received four offers, each reasonable and well over $2 million.  Because the seller did not want to include it we were $100,000+ apart and unable to bridge the gap.

We will go to market again next year but with increased sales and profits and at a price that includes working capital.

As you can see from this article, while nothing is fixed and all is negotiable, if you are buying a business you MUST make sure that you have sufficient working capital to operate the business after your purchase and then some.

If you are working with Sunbelt Business Brokers on your purchase we will ensure you have enough working capital arranged or we will not do the transaction. We take great pride in the success of our clients and have a stellar record. In part this is because Sunbelt does a great job of matching the skills, experience, resources, and lifestyle goals of the buyer with the right business; it is also because we ensure that the financing for the transaction is adequate for business success. And that includes making sure that the buyer has sufficient working capital to succeed.

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