Working Capital and its Implication in Purchase Price
The final price paid for a business can heavily depend on the amount of working capital brought to the table. A dollar-for-dollar working capital impact on the purchase price could result in a reduced or increased purchase price depending on the negotiated working capital peg. The analysis determining the peg could result in a reduced company value depending on how it is calculated and the past actions that impact working capital.
Working capital will impact multiple areas of the buyer’s financial due diligence, including adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) and debt analysis, impacting the final purchase price.
Let’s discuss what comprises net working capital, how to calculate the peg, and what are working capital adjustments.
What is Working Capital?
Generally, working capital is equal to current assets minus current liabilities. This financial metric represents the company’s available operating liquidity. If current liabilities exceed current assets, the business has a working capital deficiency.
Your company might have assets and profitability, but without assets that can quickly be converted into cash, the company falls short on liquidity. Positive working capital is critical to ensuring continued operations and satisfying maturing short-term debt and upcoming expenses.
Managing working capital means good management of accounts receivable and payable, cash, and inventories.
Current assets include the company’s cash and cash equivalents, accounts receivable, and inventory. Current liabilities include the company’s accounts payable, credit cards, and payroll and accrued expense liabilities.
How To Calculate the Peg and the Importance of the Calculation Period
The working capital peg is set using the latest balance sheet as the acquisition closes. Using the basic formula of subtracting obligations from assets is only part of the picture. There is also a “true up” adjustment, typically 90 to 120 days after closing.
The main issue for calculating the working capital percentage is how long of a look-back is used to create an average.
With the disruptions of the last few years, a twelve-month lookback could be very skewed. Sellers and buyers have to come to a period they mutually feel is acceptable.
If the seller had acquired inventory inexpensively before a dramatic shortage and price increase nine months ago, a twelve-month lookback is to their benefit. The benefit would move to the buyer if a three-month lookback was agreed to that reflected the higher costs and values of the inventory. This example shows why sellers traditionally want a longer time frame and buyers want a shorter period.
At the 90-day true-up, the seller might receive a larger check if the trailing-twelve months financials were used, and inventory was cheaper. Conversely, the buyer might pay less if a shorter period reflects less variation in costs.
Seasonality is another potential factor in calculating the peg. If the purchase is coming at the end of a slow season, the buyer benefits when using a shorter lookback. If the seller wants a short lookback but is completing the deal during peak season, the buyer will stand to make more.
During the due diligence period, the seller will deliver a working capital estimate they believe the company will have at closing. Should this amount exceed the target (peg), an equal amount to the excess will be received as part of the purchase price.
For the inverse, if the estimate is lower than the target, the buyer reduces the purchase price.
Once the deal is closed, the buyer will calculate the amount of working capital the business had at closing, further adjusting the price if the buyer’s calculation differs from the seller’s estimate. This process is often called the “true up.”
How To Increase Working Capital
There are several ways to increase working capital before a sale and realize greater profits on the sale of your company. Here are the main ways to do so.
Invoice right away
Collecting from customers faster increases working capital for your company. Keep your customers happy but also bill them as early as possible. Send the invoice as soon as the goods or services are delivered.
Get Professional Advice
Entrepreneurs often need help finding new solutions for improving working capital. Professional M&A advisors will thoroughly assess the company, evaluating the sales cycle, inventory turnover, and credit terms. A professional will find areas with room to improve and ways to generate more cash.
Working Capital Is a Big Consideration
If this is all new to you, don’t sweat it. Most business owners have never had to contemplate the impact of working capital on selling their company, and it’s a fairly complex variable. Going into negotiations, you want to be in the strongest position possible with your working capital.
The best strategy for increasing your working capital position is partnering with experts that have helped others structure their businesses to sell. They have innovative solutions that will help you increase the value of the final sale and ensure your walk away happy.
Quantive M&A and valuation experts have helped companies of all types improve the working capital equation and walk away winners from the biggest deal of their lives. Schedule a call with a Quantive expert to structure your business for sales success.