Why Is Working Capital So Important?
A business is not static. It is a bundle of ongoing relationships between customers, suppliers, employees, and other stakeholders. Invoices go out. Cash comes in. Payroll accrues. Bills come due.
Working capital is constantly in flux. Defined as current assets minus current liabilities, it measures a business's short-term financial health. Without enough working capital, a business may face a liquidity crunch.
Working capital is also a part of what the buyer wants to purchase. Small businesses are usually valued on a multiple of earnings, and those earnings depend on working capital. That makes working capital relevant to the purchase price.
But all this makes buying a business tricky. The amount of working capital in the business changes from day to day. Depending on when the deal closes, the business could have more or less than expected. If there is too little, the buyer may not have enough to meet near-term obligations and may not receive the full benefit of her bargain.
At the same time, sellers often view working capital as a cash grab. In their view, the business’s cash and accounts receivable are theirs. They earned them; they want to keep them. Sellers therefore sometimes push to exclude working capital from the deal altogether.
This is why working capital is a pressing issue. If raised for the first time late in the process, it can feel like the buyer is reopening the economics of the deal. If raised early, it is easier to frame as part of the bargain.
For these reasons, buyers should identify the business’s normalized working capital needs early, negotiate a clear target, and include a closing adjustment mechanism if needed. Done correctly, the business receives sufficient operating liquidity without turning working capital into a perceived retrade of the purchase price.
As a buyer, you must:
Determine how much working capital the business needs
Agree with the seller on the amount that should be delivered at the closing
Decide whether the purchase agreement needs a mechanism to adjust the price if the amount delivered is too low.
1. Determine how much working capital the business needs.
To complete a successful acquisition, you need to understand the target’s working capital needs. As the buyer, you must determine the amount and type of working capital required to fund near-term operations.
Do not underestimate this issue. Insufficient working capital can make the first few months of ownership difficult, require additional personal funds, or, at worst, leave the business insolvent.
Common components include accounts receivable, excluding receivables over a certain age; inventory, excluding slow-moving or obsolete inventory; and accounts payable. Cash is often, although not always, excluded. The exact mix will depend on the target business and the circumstances.
Key questions include: How much inventory does the business consume during a typical operating cycle? Are there non-recurring items that should be excluded? Do you need to account for recent changes in accounting methods?
Because working capital should reflect the ordinary operating needs of the business, the measurement period matters. The typical operating cycle is 12 months, but a different period may be appropriate. If you are acquiring a seasonal business, you may want to exclude inactive months. Your calculations will also depend on whether you are buying during the active or quiet part of the year.
In any event, the goal is to identify the normalized amount of working capital that should be included in the deal. This is the level of working capital the business has historically needed to operate, and the amount implicitly included in the purchase price.
2. Translate those needs into a peg and adjustment mechanism.
Once you understand the business’s working capital needs, you must agree on them with the seller. Because working capital can directly affect the purchase price, expect these negotiations to be contested.
As the buyer, you will want a higher number to protect your interests. The seller will want the lowest number possible to extract maximum value from the deal. The agreed number is called the working capital peg or target.
You may then wonder:
Since working capital is always in flux, how can I know if the seller will leave the correct amount in the business at closing?
That is the role of the working capital adjustment, which is included in the purchase agreement.
If the business is delivered with less working capital than the peg, the purchase price is reduced. If the business is delivered with more working capital than the peg, the purchase price is increased.
The working capital adjustment is implemented as follows:
Before the closing, the parties agree on an estimate of the closing working capital.
Based on that estimate, the purchase price is adjusted up or down.
Between 60-90 days following the closing, the parties review the books and records of the business to ascertain the actual closing working capital.
Based on the difference between estimated and actual closing working capital, the purchase price is adjusted again.
To address possible disputes, the parties include a resolution procedure giving an independent accountant the final say on the working capital calculation. And depending on the complexity of the business, the parties may agree to a single closing adjustment and forgo the post-closing true-up. In many small business acquisitions, this is possible and allows the parties to know the final purchase price at closing.
Just be warned: SBA lenders are idiosyncratic about working capital adjustments. Some will not allow them at all. Others will allow an adjustment at closing but not a post-closing true-up. Discuss these issues with your lawyer.
3. Decide whether a working capital adjustment is worth the friction.
Despite the importance of working capital, it is possible to close without a working capital adjustment. Depending on the target business, it may even be easier to exclude working capital. For example, if the seller does not understand the concept and has not retained suitable advisors, insisting on an adjustment may put the deal at risk.
But you can only go this route if you have sufficient means to fund the business’s working capital independent of the seller. Many lenders will agree to a working capital loan or line of credit, and for a small business, those may be enough. And even if you exclude most components of working capital, you and the seller may still want to adjust for work in progress to account for underbillings or overbillings on active customer projects.
Do not leave yourself with insufficient working capital. That is one of the few universal rules of buying a business. If you exclude working capital, you still need a plan to fund the business after closing, and the purchase price should reflect the value the seller is retaining.
Working capital is not just an accounting concept. It is part of what the buyer is paying for and part of what the business needs to survive. Whether you use a full adjustment mechanism, a simplified closing adjustment, or a purchase price reduction, do not let the business reach closing without enough working capital to operate. That is why working capital is so important. If you do not have enough at closing, your time as an entrepreneur could be short-lived.
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