Working Capital Negotiated Component of Business Sale
The term working capital refers to the difference between a company’s current assets and its short term liabilities. A company’s current assets comprise its cash, Accounts Receivable (A/R), and inventory. Short term liabilities comprise debt and accounts payables (the company’s obligation to pay for goods or services received on credit). The working capital of a business does not reflect the value of the business when it comes time to sell. The value of a business depends upon its future cash flow (demonstrated by its current adjusted owner benefit) and the included tangible assets. Indeed, the cash component of working capital is almost never included in small business sales, while the disposition of the accounts receivable and inventory are generally subject to negotiation between the parties. In some larger business deals, buyers expect that a sufficient level of working capital will be included in the sale so no extra cash needs to be injected in the business after the sale.
Working Capital Significantly Fluctuates
In order to understand how working capital affects business sales, it is important to remember that working capital is subject to large fluctuations. As such, it is almost impossible for two people to come up with the exact same answer as to the true net working capital needs of most businesses. For example, the cash appearing on a company’s balance sheet may dramatically fluctuate due to seasonality, timing of tax payment obligations, and the owner’s personal desire at any given time to keep a large amount of cash. Likewise, a company’s inventory and Accounts Receivable are subject to dramatic fluctuations due to seasonal and cyclical factors. In larger business deals where all components of working capital are included, the parties will set a target of normalized working capital subject to revision after the closing date.
Assume ‘Cash-Free’ and ‘Debt-Free’ Transaction
Unless the business listing says otherwise, buyers should always assume that the deal terms of a business for sale is priced on a ‘cash-free’ and ‘debt-free’ basis. The company’s cash is thus not included in the sale (as it rightfully belongs to the seller) and the company’s debt and accounts payables are not the responsibility of the buyer. This general rule of thumb helps keep the sale of a business easy and simple to implement for both parties. It also fairly holds the seller responsible for the company’s debts and payment obligations while allowing the seller to keep their own cash. Importantly, a ‘cash free’ and ‘debt free’ transaction does not mean that no working capital is included in the sale. The other components of working capital – inventory and accounts receivable – are often critically important to business sales.
Disposition of Inventory
Inventory represents goods produced by a business that are available for sale, including the raw materials used to produce such goods. A company’s inventory appears on its balance sheet as a short term current asset that is expected to be converted into cash within one year. Most retail-related businesses have a large amount of inventory as the primary component of their working capital. This is especially the case when a retail business purchases their inventory on favorable terms which reduces the cash required for working capital needs. Parties to retail-related business sales often treat the inventory separately so they may avoid possible state sales tax liability and so the goodwill of the business is valued more transparently. For most other business transactions, inventory is typically included in the sale (but always negotiable).
Disposition of Accounts Receivable
The disposition of the Accounts Receivable as a component of a company’s working capital is often dependent on industry-specific norms and what is most practical between the parties. In most small business sales, the seller retains their A/R since they incurred the expenses in providing the goods and services. As a practical matter, however, it is often difficult or cumbersome for the seller to collect their receivables after the closing. The seller often allows the buyer to collect the A/R on their behalf as a negotiated term under the purchase agreement. Health-care related firms for example carry a large of amount of A/R since they bill in arrears to third party payors. In such cases, the seller must retain their billing infrastructure after the sale in order to collect the A/R. When the A/R is included in the sale, the asking price of the business should be adjusted to reflect its discounted value.
Working Capital Affects Buyer’s Return on Investment
Even though the cash, inventory, or A/R components of working capital may not be included in a business sale, the amount of working capital required by a business still affects a buyer’s Return on Investment (ROI). The ROI of a business opportunity is its net profits (or adjusted owner benefit) divided by the total cost of acquiring the business. The total costs to the buyer of acquiring a business should reflect the normalized working capital needs of the business. Although the cash, A/R, and inventory may be retained by the seller, the buyer must nevertheless carry a normalized level of working capital as a part of operating the business. After adding working capital (that is not included in the sale) to the purchase price of a business, the buyer’s ROI will go down. Sellers of businesses should be aware that a buyer’s lower ROI will in turn reduce the valuation multiple the buyer will be willing to pay for the business.
Most business transactions occur in a ‘cash free’ and ‘debt free’ basis where the seller retains their cash and extinguishes all debts and accounts payables upon closing. The value of the business must always be adjusted to reflect whether the inventory and Accounts Receivable components of working capital are included in the sale. In general, the higher the normalized level of working capital required, the lower the valuation multiple of the business.
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