Mastering Working Capital in Business Acquisitions

Working Capital is arguably the most important (and often overlooked) element when buying a business.  This is a must read and could save your behind!

What is Working Capital?  The textbook definition (yawn):  The difference b/t a company's current assets and current liabilities.  This difference comprises the financial resources needed to fund the day-to-day operations of a business.

Think payroll, inventory purchases and other operational costs...  You need working capital to keep the "machine" that is the business operating.  Some common analogies:  • Gas in the car • Blood in the body • Water in the water wheel • Batteries in the flashlight

Simply put, working capital is just another core asset of a business.  For ex, imagine buying a towing company without enough tow trucks.  You'd immediately need to buy more trucks, right? This would indirectly increase the purchase price. Working capital is no different!

Why Should the Seller Leave Working Capital?   Why can't you just bring your own working capital?   In its purest form, a small business acquisition is nothing more than the acquisition of cash flows.  You're buying a machine that generates money.

When you buy a small business, the valuation is almost always established by applying a 2x to 5x multiple to the historical earnings.  Simply put, you're using historical results to predict the target business's future cash flows.  It's not perfect, but it works.

To acquire cash flows, you have to buy all of the assets that comprised the business at the time it produced the historical cash flows upon which the valuation is based.  This includes tangible things like equipment and inventory and intangible things like IP and contracts.

The assets that comprised the business at the time it produced the historical cash flows also include... you guessed it... the working capital utilized to facilitate the operations!

Much like the tow truck example above...  In the absence of a "normalized level" of working capital, you must immediately inject capital into the business to keep the machine running.   This indirectly increases your purchase price.  This is bad!

How Do We Account for Working Capital?  In most M&A deals, working capital is accounted for through a somewhat complex construct that is heavily negotiated.  As a starting point, what comprises "current assets" and "current liabilities" is often fought over.

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"Current Assets"   Includes these things:

• cash and cash equivalents*

• inventory

• accounts receivables

• prepaid expenses  

*typically excluded! The buyer will seek to narrow these terms by, for ex, reducing A/R to a certain age limit.

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"Current Liabilities"  Includes these things:

• accounts payable

• accrued expenses

• accrued tax

• deferred revenue  

And the inverse of above, the buyer and seller will try to broaden and narrow these terms, respectively.

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The "Target"   When you buy a business, you should acquire a "normalized level of working capital."  What does "normalized" mean though?   This is super important...

Normalized means what the business *needs* to operate.   A trap for the unwary!   Buyers often look at what the business *had.*   We do not care how much working capital the sellers kept on the balance sheet.   We want to know what it needs to operate.

[*Note that what the business needs going forward and what it needed historically is different b/c you will have debt payments the seller didn't.  You can only ask the seller to provide what it needed historically. Your debt is not their problem.   Talk to your lender!]

This number... what the business *needed* ... is your "Target"  In non-SMB/SBA Land, you set forth the target in the purchase agreement.  The purchase price is then adjusted up or down at closing based on the "Estimated Working Capital" at closing measured against the Target

There is then a post-closing adjustment between 60 to 90 days after closing where the Estimated Working Capital is adjusted based on the actual "Closing Working Capital."  But let's move past this b/c in SMB/SBA Land, it largely doesn't matter...

Welcome to SMB/SBA Land!  Here we are, way down market.   Down yonder, sellers don't understand working capital.   A buyer once reported that a seller said to him:   "Working Capital? Sounds like a YOU problem!"

So How Do We Handle Working Capital?   We keep it simple!   Talk to the broker about the issue. Gauge the seller’s willingness.   If you get strong push back, you go with Option 1.

Option 1  Underwrite the deal to account for working capital by reducing the purchase price.   Then never mention it to Mr. Seller!  While he's bickering with other buyers, you'll come across as easy to deal with. Great!

Option 2   If the broker indicates that seller is open to working capital.State in the LOI that the business l will be delivered with a "normalized level of working capital."   [Note that you don’t have enough information at the time of LOI to determine this amount. After LOI, keep it simple!  [Note that SBA lenders often have issues with post-closing adjustments, so a typical working capital true-up will not be possible. It's crucial to get the WC right at closing, which can be challenging.]

As a result, most buyers simply ask for a set amount of accounts receivables and inventory  (usually a combination thereof) at closing.   Nothing fancy, just a tranche of current assets on the balance sheet at closing.

Note that this only works in an asset deal, where the seller retains all of the current liabilities.   In a stock deal, you have to make sure that all current liabilities are accounted for and paid off at closing.

One Final Point  Watch out for "deferred revenue"!  For example, pre-paid obligations like subscriptions with up-front payments for services rendered later.  Mr. Seller makes off with the upfront cash, while you’re left to provide the services.    This is bad!

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TLDR

•  Working capital is a core asset of the business, like any other

•  If you don't have enough working capital, you'll have to inject it, increasing the price

•  Keep it simple in SMB - either lower the purchase price or ask for a simple tranche of current assets

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**Please note that all information provided in this thread or otherwise by is intended strictly for educational and informational purposes and not in seeking pecuniary gain or legal employment. Consult your own attorney.**

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