While running a business, it’s easy to take financial shortcuts. Taxes cost a business 35%, most accounts receivables are net 30, and working capital is cash required to run a business. Normally, as long as an entrepreneur has a good accountant, shortcuts in understanding aren’t a big deal. However, when it’s time to sell a business, understanding financial terms can be the difference between a good deal and a bad deal.
One common misunderstanding is how working capital and cash relate. It surprises many entrepreneurs that they have to leave the working capital “in” the company when they sell. If working capital (in the simplest terms) is assets less liabilities, most believe their only obligation is to leave a balance sheet of $0 and walk away with all other cash. However, the reality is different and more nuanced.
Calculating Working Capital
Working capital is the measure of a company’s liquidity and is factored into valuations. In essence, acquirers buy working capital in a perfect dollar-for-dollar exchange when they buy a company. What an entrepreneur can take away – usually – is excess cash, common stock or retained earnings. But only if those are not figured into the working capital. In a perfect case, they will not have been, though not everything is clear if you only use the basic calculation. The classic formula for working capital is simple:
Working Captial = Current Assets – Current Liabilities
“Current” usually means maturing within the next calendar year. But this formula is too simplistic for purposes of a sale and open to loose interpretation. Do current assets include cash and common stocks? Do liabilities include taxes? While the entrepreneurial instinct to subtract assets and liabilities is close, it’s incomplete. A more precise (but still simplistic) formula is to look adjusted working capital (AWC):
Adjusted Working Capital = Accounts Receivable + Inventory – Accounts Payable – Accrued Operating Liabilities
Both formulas use balance sheet values but diverge in one important respect. The classic formula may or may not include cash as an asset where the AWC formula does not include cash at all. The nuances aren’t always critical when running a successful business, but can be extremely important in negotiating a sale.
Working Capital During a Sale
You must understand your company’s working capital needs before you sell. Work with your financial advisors to determine exactly what the business needs to operate and what capital is excess. By clearly delineating the difference between working and excess capital, you’ll better understand your company’s valuation. You’ll also be able to spell out everything in the letter of intent and in the contract.
But no matter how tight the contract, you should expect that adjustments will happen after closing. Working capital is a moving target that changes every time a company places an order, receives payment, and so forth. This is why sellers and buyers agree on a working capital target or working capital peg. It is an educated guess of what AWC will be at closing, based on historic balance sheets. The historic period is typically a year, but may be just a few months in the case of a meteoric startup (and if the buyer agrees). The target will not be precise, and one party will owe the other a ‘true-up’. In the case of a deficit, the seller owes the buyer, and in the case of a surplus, the buyer owes the seller.
As part of negotiating a sale, you may agree to leave some of that excess cash in the coffers for operating expenses. Buyers may not wish to pay cash out of pocket to keep the business running. It’s all negotiable. Operating cash is much like buying a home where buyers can make offers based on the seller paying closing costs or you can choose to pay closing costs to sweeten a deal. Holdbacks are often part of the negotiation. Excess capital is left in the business for 90 or 120 days to cover any adjustments with the leftover capital returned.
While the negotiations may seem amicable enough, not every deal is easy and clean. In the worst of cases, the acquirer disputes the working capital – claiming it was nowhere near the target. Barring misbehavior on either side, sometimes what goes wrong is simple and hard to avoid. The problem occurs because the seller and buyer used different calculations for the working capital target. If the difference is significant and the two parties can’t come to an agreement, a lengthy and torturous process of litigation and forensic accounting can occur.
There are dozens of specific causes of those mismatched figures, but here are a few that are typical:
- The seller may not have figured taxes into liabilities: taxes are not invoiced and may be figured elsewhere in the operating budget.
- The parties may disagree on a cut-off date for that post-close true-up. A shorter period calls for more speculation by the acquirer, and the acquirer may naturally figure in their own favor.
- The parties disagree on materiality – that is, information that was material to the buying decision. This is a problem of due diligence. The seller may have a stack of unrecorded invoices, have overestimated the useful life of inventory, have failed to disclose pending litigation, etc.
A well-executed contract (backed up by well-executed diligence) is always the answer. The contract should allow for as little interpretation as possible. Accountants on both sides should spell out the accounting policies to the letter and add them to the contract. Getting everyone on the same page before the deal is closed will solve a lot of problems.
Knowing the conditions of your business before you ever start makes the process much easier. One straightforward way to be ready for any potential transaction is to clearly understand how your business operates, what to expect for the capital currently in your business, and what capital is the excess you can take with you.
Check out an additional resource on Net Working Capital.