While most business owners fundamentally understand working capital within their business, they are not often prepared for it to be part of a letter of intent when selling. Working capital adjustments can be an emotional and messy part of a transaction, but they don’t need to be if you are armed with knowledge.
Working capital is typically calculated as the sum of the business’s current assets (excluding cash) minus the sum of its current liabilities (excluding debt). From a more practical standpoint, it measures the value of inventory sitting in your warehouse and money customers owe you against the bills you need to pay, like payroll, rent and vendors. Working capital can vary month to month, particularly in seasonal businesses.
The buyer’s goal is to ensure that the business is being operated in a similar manner in the weeks leading up to closing and working capital is one way to measure this. You and the buyer will negotiate a working capital target — an amount of working capital that the buyer expects the business to have at closing. Your purchase agreement will specify what happens if the company’s working capital is higher or lower than this target.
There are generally three mechanisms used to resolve a difference in the actual working capital at close versus the target.
- Minimum threshold: A threshold will require working capital to be at or above the minimum value. This is a simpler calculation but will not provide you any upside if working capital is higher at closing.
- Collar: The buyer and seller will agree upon a range of working capital that is appropriate at closing. There will be no adjustment to purchase price unless the working capital at closing is above or below specified range.
- Dollar-for-dollar adjustment: This calculation will adjust the purchase price up or down for any difference in the actual amount of working capital at closing versus the target.
A buyer will often base the target off a 12-month average and will be looking back at your historical financials to evaluate trends. So, like many other deal elements, you need to manage your working capital needs well ahead of a sale if you want a lower target.
You can permanently reduce your capital requirements using a few core strategies:
- Be vigilant about collecting your accounts receivable and not allowing your customers to use you as their piggy bank.
- Be mindful of your inventory days on hand. Inventory can be like a warm, cozy blanket that helps you sleep at night, but business owners often have too much money tied up in inventory.
- Seek out help from your vendors to reduce your working capital requirements. Your vendors may be willing to hold inventory for you or may be willing to offer discounts for early payments. Longer payment terms from your vendors may help you to better align the timing of your customer payments and your vendor payments.
Taking control of your working capital well ahead of a transaction will allow you to put money into your own pocket versus leaving the opportunity to the next owner. ●
Corrie Menary is a Partner with Kirtland Capital Partners
