When you're buying or selling a business, understanding and negotiating the working capital adjustment mechanism is critical. While most people recognise that good working capital management can help to optimise cashflows and mitigate funding pressures, many entrepreneurs don't realise the critical impact of working capital in negotiating the selling price of a business.
Alan Max, Director of Moore Stephens Sydney, explains how working capital can impact a deal price and offers useful tips to ensure you don't miss out in negotiations.
What is working capital?
Actually, there's no standard definition for working capital, as it varies from business to business. Generally speaking, though, it's the capital tied up to fund your day-to-day business operations, particularly purchasing and holding inventory, and then converting this to accounts receivable before cash is received. In most cases, it's more complicated than current assets less current liabilities, as some of these aren't working capital in nature. For instance, while a bank overdraft can be used to fund working capital, it's not working capital itself.
How does working capital affect your transaction
While buyers want to ensure they're acquiring a business with sufficient working capital to generate "purchased" earnings, sellers seek to minimise working capital in the business. So, negotiations typically take place to reach a target working capital amount, which is documented in the sale agreement, including working capital inclusions and exclusions.
In reality, the working capital at the business handover date often differs from the agreed amount, so a working capital adjustment is made to the purchase price. This simply means that the "base" purchase price is adjusted up or down.
Five tips to help you optimise the working capital outcome in a transaction
1. Make sure you understand the target working
Target working capital is often the average working capital a business needs to operate efficiently. Determining target working capital can be subjective, as it could be based on:
- A company's historical working capital level; and/or
- The working capital level of comparable companies in the industry.
So, you should negotiate a target working capital level based on a detailed analysis of the estimated working capital requirements of a business. And, as a buyer, you should ask and understand "What's the industry norm and how much cash will be tied up in this business?"
2. Pay special attention to seasonal
For a business with seasonal sales or purchases, the working capital impact may be significant at certain times of the year. And, without an adequate working capital adjustment on purchase, the buyer or seller can be disadvantaged.
For example, a cleaning product distributor with a stock buildup at the end of Quarter 2 ("Q2") and Quarter 4 ("Q4"), as shown in the diagram. The buyer wants to use the average working capital from the last two years of $100K as the target level and the deal closes at the end of Q2 2012 when the working capital level is $160K.
In this case, the excess working capital of $60K should be added to the purchase price. Similarly, if the deal closed at the end of Q3, when working capital was $70K, the $30K working capital deficit should be taken off the purchase price.
3. Always clearly define working capital in the sale
A clear definition of working capital is critical. It must reflect the true short-term funding requirements of the business. Disputes can arise from imprecise or vague definitions of working capital in the sale agreement, often involving sizeable amounts and requiring the help of lawyers and experts.
So, to avoid this situation, it's best to analyse the detailed balance sheet over time, then clearly match the possible balance sheet accounts with the working capital defined in your sale agreement (that is, whether they're included or excluded).
4. Consider verifying reported working capital
Buyers beware: the financial accounts of some small or medium sized enterprises (SMEs) often don't sufficiently recognise doubtful debts and stock provisions, resulting in overstated working capital. So, if you're a buyer considering investing in an SME, especially one without audited financial statements, be cautious. Arranging for a financial due diligence to verify reported working capital assets (amongst other things) would be a very good investment.
5. For peace of mind, seek the right professional
There's no doubt that the financial impact of a poorly negotiated working capital adjustment can be significant. An experienced professional can provide valuable assistance when negotiating the sale price mechanism, removing uncertainty and providing you peace of mind.
At Moore Stephens, our corporate finance and transaction specialists are experts at working capital matters, with a strong reputation for helping both buyers and sellers achieve optimal results. We'd be happy to share more tips with you and work with you to ensure you, too, will optimise the working capital level in your next business transaction.
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