When an offer is presented to a seller, how the buyer plans to address working capital is an important consideration. As the cost of capital has increased over this past year, working capital has become more and more of a negotiation point between buyers and sellers. Without a good understanding of the working capital requirements for a particular business, sellers could be leaving their hard-earned money at the closing table.
Below are a few key questions to consider when addressing working capital in a transaction.
1) How is working capital calculated?
To understand why working capital can be hard to determine, just do a quick search for “working capital” and see how many different results come up. While the simplest definition for working capital is “Current Assets – Current Liabilities,” this by itself may not be the best way to calculate it for a specific business.
Our firm represents many B2B businesses where working capital is a significant part of the transaction. The biggest driver in working capital is how the receivables and payables are being managed and how payment terms are set up. One company may have primarily clients who are paying 90+ days out. Another company may have a much tighter payment cycle that minimizes cash flow requirements making it more attractive for a buyer to finance.
A good rule of thumb is calculating the running monthly average over 12 months for the difference between current assets (including inventory) and current liabilities. While this method can help account for seasonal variables, higher or lower working capital requirements still may be required depending the time of year the transaction closes.
When traditional methods are not as practical, a simpler method is calculating the monthly fixed overhead costs of the business including the building lease/payment, utilities, payroll, and other recurring monthly expenses. For a B2B business with more traditional payment terms, the working capital requirement may be 2-3 times the monthly fixed costs.
Comparatively, a B2C business with more immediate cash/credit terms may only require 1-2 times monthly costs. Other considerations are the type of transaction (stock vs asset) and whether certain amounts of assets and liabilities are being assumed by the buyer at closing.
2) How is working capital negotiated?
It’s essential to have a good understanding of the working capital requirements before an offer is presented. Since working capital sources can be based more on the buyer’s financial capabilities and resources, it’s difficult to know up front how a buyer will address working capital in an offer.
For example, we recently represented a specialty contracting business where the buyer’s lender was driving the working capital requirements for the business. While our client was required by the lender to assign a small portion of the current assets at closing, we negotiated a significantly higher seller carry note on top of the agreed upon purchase price to offset this amount at closing. This client had received LOIs from industry buyers demanding more than double the amount of working capital than the buyer’s lender required. At the closing table, our client was able to retain a majority of the accounts receivable which translated to over a $1M difference in working capital between the different offers.
Working with an experienced firm that takes the time to fully understand working capital requirements specific to the business increases the likelihood that the transaction becomes more equitable for both the buyer and seller. The majority of our business comes from referrals, and we appreciate your continued trust in our firm.
Robert W. Amerine
President, CBI, M&AMI