What is working capital? Working capital represents the short-term liquidity and financial health of a business. Positive working capital can indicate the business is well-managed and financially stable. Working capital is the money available to meet current, short-term obligations. It is calculated by subtracting short-term liabilities from short-term assets. Short liabilities include accounts payable, salaries, taxes, and other debts/accrued expenses. Short-term assets include cash, accounts receivable, and inventory that will be converted into cash within twelve months.
Seven Reasons Why a Buyer May Expect Working Capital to be Included in the Sale Price of a Business
Oftentimes, sellers are taken by surprise when a buyer demands a specific amount of working capital to be included in the sale price of a business. In lower-middle-market valuations based off EBITDA multiples, working capital is included in the price. In main street business valuations based off SDE multiples, working capital is not included in the price. However, with a stumbling economy, more sophisticated lower-middle-market buyers are reaching down into main street businesses and applying their expectations to main street acquisitions. So, why would a buyer want to include working capital in the acquisition?
Here are seven reasons why a buyer may expect working capital to be included:
1. Ensures Business Continuity
Working capital is essential for the day-to-day operations of a business. By including working capital in the sale price, the buyer ensures the business will have sufficient funds to continue its operations smoothly after the acquisition.
2. Creates Seamless Transition
Working capital helps create a smooth transitional period during which the buyer takes over the operations. By including working capital in the sale price, the buyer has immediate access to funds to cover initial expenses, pay suppliers and employees, handle any unexpected costs, etc. during the transition.
3. Avoids Additional Investments
Working capital avoids the need for the buyer to inject additional capital just to maintain the current operations of the business. By including working capital in the sale price, the buyer can avoid having to make an additional investment immediately after the acquisition.
4. Mitigates Risk
Working capital can indicate the business is well-managed and financially stable. By including working capital in the sale price, the buyer reduces the risk of acquiring a business that may be struggling to meet its short-term obligations.
5. Simplifies Negotiations
Working capital simplifies the negotiation process. By including working capital in the sale price, instead of negotiating a separate amount for working capital, both parties agree on a total purchase price that includes the estimated working capital needed to operate the business.
6. Avoids Disputes
Working capital can be a contentious issue in negotiations if not explicitly addressed. By including working capital in the sale price, both parties avoid potential disputes or disagreements over the specific amount of working capital at the time of the sale.
7. Simplifies Handing of A/R and A/P
Working capital simplifies the handling of accounts receivable (A/R) and accounts payable(A/P) after the sale. By including working capital in the sale price, A/R and A/P do not need to be allocated between the buyer and seller. The buyer can simply receive revenue and pay bills as if the sale never occurred.
It is important to note the inclusion of working capital in the sale price should be clearly defined in the purchase agreement. Both parties should agree on the methodology for calculating the working capital amount, any adjustments, and the target working capital amount at the time of the sale. Proper due diligence is crucial to ensure the working capital included in the sale price accurately reflects the needs of the business and is fair to both parties.
Sources: Bank of America and Chat GPT
Eric J. Gall
Edison Business Advisors
Eric is the registered broker and founder of Edison Business Advisors. Over the past 25 years, Eric has participated in many forms of business transactions closing in on $300M. He has earned 34 awards from BBF, IBBA, and M&A Source since 2010. Eric is the President of BBF Southwest Florida Region and serves on M&A Source Deal Market Committee and BBF State Board.