ONE OF THE MOST CRITICAL COMPONENTS OF YOUR SALE IS SOMETHING YOU MAY NOT EVEN BE AWARE OF…
All business owners have considered this significant decision at one time or another: Am I ready to sell my business? As years pass and the business grows, many find themselves dealing more and more with the laborious chores of the operation (back-office work like compliance, HR and accounting, for example) and less with what made them enjoy the journey so much, things like connecting with people, driving growth or being out in the field. Additionally, many owners find themselves with a disproportionate amount of their net worth tied into this one asset – maybe it’s time to diversify and take some “chips off the table,” or perhaps make a full exit if this stage in your life has run its course.
Regardless of where you are in the life cycle of your business, you’ve probably heard some anecdotes about the multiples paid for businesses in your industry, giving you a ballpark idea of what a sale might look like for you. However, while the headline number or “purchase price” may be the only figure on your mind, there are several other factors you should be aware of before moving forward with a deal that can affect take-home proceeds. At the very top of that list is a term you may or may not have heard before: Working Capital.
If you’re not familiar with the concept of working capital, don’t let that worry you. In our experience, many sellers are unaware of what it is or how it can influence their take home proceeds. Fortunately, the concept itself is straightforward, keeping in mind that the exact definition can be somewhat variable based on the specifics usually agreed upon by the buyer and seller. With that caveat in mind, Working capital is a liquidity ratio that represents your business’s operating liquidity, which is defined as Current Assets less Current Liabilities.
Current Assets: These represent all the company assets expected to be sold, consumed, used or exhausted through standard business operations with one year (cash, cash equivalents, accounts receivable, inventory, prepaid expenses, etc.)
Current Liabilities: These represent a company’s short-term financial obligations that are due within one year or a standard operating cycle. (accounts payable, accrued expenses, short term debt, notes payable, etc.)
Simply speaking, as a seller you can’t just sweep the cash accounts, leave all the debts and pass the torch to a buyer. Nearly all transactions we see are structured on a cash- free, debt-free basis and therefore cash is excluded from current assets and debt is excluded from current liabilities. Upon a sale, the implication is that the seller keeps all the cash in the accounts while simultaneously delivering the company free and clear of all debt and debt-like items.
However, a buyer will require a specific (or target) amount of working capital to be left in the business to meet short-term obligations and run day-to-day operations. A buyer will want to comfortably know that they will not need to deploy additional capital on Day One to keep the lights on.
Now you may be wondering, how do you choose a working capital target or “Peg”? The most common method is to calculate a 12-month historical average (to capture any seasonality in the business). With help from your accountant or advisor, you can analyze historical monthly balance sheets and determine rolling averages going back about 24 months. Working Capital analysis is a process that we at SF&P Advisors have specialized in for decades now. We can help you determine the highest (least favorable) and lowest (most favorable) working capital average or “Peg,” giving you the visibility to effectively negotiate the deal point.
Keep in mind that the items you ultimately negotiate are subject to change at closing based on several factors, including seasonality, change in demand, change in payment terms, etc. Also note that this is a moving target as each month passes (“true-up” happens traditionally at or within 60 or 90 days of close). We cannot stress enough to sellers the importance of their perception of working capital and understand that a fair amount of money to run operations is one of the assets they’re selling with the business. Ask yourself, “Is my business worth the same amount if I take away all the money it needs to run tomorrow?”
Working capital is a critical part of the transaction. Both parties must understand it and agree upon it. Typically, buyers don’t like to set the “Peg” or methodology early in the process. Failure to understand working capital and its implications on a transaction could result in you leaving real money on the table or even losing the deal in the 11th hour. If working capital is something you’re scratching your head over, it could be worth calling an advisor and working with a professional. A seasoned advisor can help a seller traverse the complex nuances of working capital and other deal points, particularly when you have Private Equity (PE) on the other side of the table. They are professional dealmakers who transact countless times in their lifetime. It only makes sense to have a professional advocating for you, since you likely will only transact once.