The how, what and why of selling your business: Understanding the impact of working capital

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Working capital can drastically impact your sale proceeds. Walk away with more by understanding how.

My final article focuses on the role of working capital in the sales process – a topic I mentioned briefly in Part 1.

Working capital needs vary from business to business and there is no standard definition. But in general terms, working capital is the capital that is tied up to fund your day to day operations. The amount required usually increases in line with your business’s size.

While most business owners recognise that good working capital management can optimise cash flow and alleviate funding pressures, many fail to understand the critical role of working capital when they sell.

How does it affect your transaction price?

Buyers and sellers typically have different ideas about how much working capital should remain in the business.

Buyers want to ensure there is sufficient working capital to trade without having to inject any cash, so they prefer a generous amount. Sellers prefer to minimise working capital because they will pocket more of the sale proceeds.

In the sale run up, sellers can and do manipulate working capital accounts to favour them. A way to increase certainty and avoid arguments is for both sides to negotiate a target working capital amount that is mutually acceptable. The amount is documented in the sale agreement, along with what is included and excluded in working capital calculations.

Given the length of the sales process and normal business fluctuations, the level of working capital at hand over time often differs from the agreed amount, so the base price is adjusted up or down.

The amount at stake can be significant. However, the amount is only known after the sale agreement has been signed so it’s too late to negotiate or turn back. Take the time now to understand how the working capital adjustment mechanism is calculated so you can negotiate it in your favour.

Optimising the outcome – five tips

1. Understand target working capital

The working capital target (or peg) should be the average working capital a business needs to operate efficiently. This is based on a company’s historical working capital level and/or the working capital level of comparable businesses.

Conduct a detailed analysis of your business’s historical working capital averages before agreeing the target figure and adjust for any unusual events. By calculating averages over a number of timeframes, you will see which one provides the most favourable (low) and least favourable (high) outcome for you so you can steer negotiations.

2. Pay attention to variations

If your businesses is based on seasonal sales or purchases, timing can make a big difference to working capital. Remember this when negotiating a settlement date.

The diagram shows a business with a stock build up at the end of quarters 2 and 4. The average working capital of $100K in 2013 was used as the target level.

moorestephensThe deal closed at the end of quarter 2 2014, when the working capital level was $160K, so the excess working capital of $60K was added to the base purchase price. If the deal had closed at the end of quarter 3, when working capital was $70K, the $30K deficit would have come off the base purchase price.

3. Define working capital clearly

A mutually agreed definition of working capital is critical and must reflect the business’s true short term funding requirements. Imprecise definitions can lead to disputes involving sizeable amounts that may only be resolved by armies of expensive lawyers.

To avoid this, analyse the possible balance sheet accounts and match them to the working capital definition in your sale agreement.

4. Verify reported working capital assets

Buyers are often suspicious of unaudited financial accounts as they can overstate the working capital required. Having an accountant verify your reported working capital assets will put buyers at ease and increase their confidence in your openness about other aspects of the sale.

5. Seek professional support

The financial impact of a poorly negotiated working capital adjustment can be significant. An experienced professional will provide valuable assistance when negotiating the sale price mechanism, remove uncertainty and provide peace of mind.

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Part 1

Part 2

Part 3

Part 4

Part 5

This is part of a series of expert SME business commentary provided by Moore Stephens. If you wish to receive the FREE eBook click here to register.

Disclaimer:

The contents of this article are generic in nature and do not represent advice that can be relied upon. You should seek professional advice based on your own personal circumstances. The author and any other parties involved in the preparation or distribution of this article expressly disclaim any form of liability to any person in respect of this article and any consequences arising from its use by any person in reliance in whole or any part of the contents of this article.

About the Author

Alan Max is Director – Corporate Finance, Moore Stephens (www.moorestephens.com.au), accountants and advisors who provide personalised and commercially astute accounting, tax and business advisory services. Drawing on over 20 years’ experience, Alan advises SMEs and smaller listed companies on exit planning, execution and valuation considerations. He can be contacted on (02) 8236 7700 or [email protected]