What is "Working Capital"?

Price and Terms offered are critical to the sale of any business. Either one, the price or the terms, can determine the success or failure of the deal.  One of the terms that we often find to be contentious is "Working Capital". Allow me to explain.

When we as individuals make normal purchases, whether it be something at the grocery store, a restaurant, or ordering an item from the internet, we typically pay cash or use our credit card.  However, when making a large multimillion-dollar purchase, like a business, generally a loan is required to finance the purchase. The buyer must use the cash flow of the business to pay back the purchase price PLUS the interest on the loan.  For that reason, the Buyer is looking for a company that produces the cash flow required to pay the loan, employees, vendors, and themselves.  When they are seeking financing, the Buyer must be able to prove to the bank that they will have the needed cash to service the debt.

This generally means that a certain level of operating capital must be left in the company at closing.  Many Sellers, even when selling the stock of the company, are reluctant to leave behind any Accounts Receivable on the basis that they “earned” that money.  Considering that all the cash is typically kept by the Seller, if all the Accounts Receivable are also kept by the Seller, the Buyer, in addition to the purchase price, would need to inject additional cash to cover the expenses immediately incurred after closing.  This is the “working capital” discussion which can become a prickly issue in many transactions.

Working capital can be defined as current assets (excluding cash) minus current liabilities.  While larger companies spend a lot of time managing working capital, generally this is not of major concern to small businesses who often operate with a very strong balance sheet.  Buyers need to understand that the historical amount of working capital may have been much higher than necessary for the business and should only expect to receive a “normal” level of working capital.

In one of our transactions, the business owner always paid off his bills immediately to take advantage of price discounts.  However, the receivables were typically outstanding for up to 90 days. This created a high level of working capital. This historical practice did not reflect the true operating needs of the company because of the owner’s conservative method for managing working capital.  We worked with the owner and his accountant to show what a “normalized” working capital amount was and suggested ways the new owner could look to extend payables, without damaging vendor relationships and speed up collection of receivables. These efforts favorably resolved the issue for both sides.

There are several ways to determine what a fair amount of working capital is for the business and it is important for the Buyer and Seller to begin these discussions early in the process and to document their intentions in the Letter of Intent or very early in the due diligence process.  Being flexible, willing to listen, and working with advisors who can understand, explain, and communicate clearly with both the Buyer and the Seller will insure that the deal gets closed in a way that is satisfactory to both parties.  At Water Street Advisors, we can do that.