Why Working Capital Matters In The Sale And Purchase Of Business?
Are you a dedicated business owner eager to unlock the potential of your enterprise? Or are you looking to sell your business but in a dilemma regarding the working capital? Do you really need to include it or exclude it while transferring the business ownership to the buyer? Come, lets discuss about it and take a final decision before its too late.
Throughout our 13 years of facilitating the sale of small to mid-sized construction companies at N3 Business Advisors, we’ve witnessed a recurring problem where the buyers and sellers find themselves fighting over working capital as deals approach the closing table. Regrettably, deals have even fallen apart sometimes due to advisors on both sides misunderstand the important role of working capital in an operational company, and how it should be calculated at the time of completing a sale of a business.
Before we address the question of whether working capital should be included in the sale price, it’s essential to grasp its fundamental importance in a running company. Picture working capital as the lifeblood of a business. Much like a person can’t function without blood, a business can’t operate without working capital. Yet another example of working capital is that; working capital is the steering wheel of a car, and if the seller is selling the car without the steering wheel, its of no use to the buyer. That is how important working capital is to the new buyer at the time of the business sale. Now coming to its calculation part, in plain terms, working capital is calculated as Current Assets minus Current Liabilities. Now what are Current Assets? Current Assets typically include inventory, cash in the bank, and accounts receivables.
Now let us consider a scenario where a business relies heavily on inventory for its operations, and if that business has no inventory how could somebody run the business? Without this essential component, the business would face significant constraints. Similarly, many businesses in the construction industry heavily depend on accounts receivables or holdbacks, often with collection cycles spanning from 30 to 90 days. Hence to ensure effective and profitable operations, businesses must have the capacity to finance these accounts receivables.
Now, picture a scenario where a buyer buys a business but fails to allocate sufficient funds to maintain a healthy level of accounts receivables or inventory. This oversight could swiftly lead to the business going bankrupt due to lack of liquidity. Hence it’s important to discuss the normal level of working capital at the early stages of buying or selling a business, well before entering into a Letter of Intent (LOI). This ensures that neither party buyer or the seller gets surprised on the closing table.
We often hear from sellers who argue that accounts receivables and inventory can be swiftly converted into cash. This raises the valid question of why they should be included in the sale of the business. Recently, we engaged with a plumbing company owner looking to sell their business. They were having an annual revenue of approximately $10 million, with an EBIDTA of around $1 million. However, their accounts receivables on an average were around $6 million, while accounts payables were less than $500,000. They were able to run the business in such a robust manner because they had a very healthy balance sheet. When they came to us, they wanted to get the value of the business based on the multiple of EBIDTA plus the working capital. We do understand their perspective; they aimed to secure a value not only for running a profitable company but also for the roughly $5 million in working capital, which can be quickly converted into cash. However, if a buyer were to buy this business, it would become into a very expensive investment, necessitating an additional $5 million for working capital, also pay for goodwill based on the expected EBIDTA multiple by the seller.
These scenarios are a common occurrence, especially in businesses where they have invested more in inventory or construction equipment etc. Many at times, we see the amount of money invested by the seller in their business does not even justify the kind of returns they are making from their business. In many cases, we’ve advised them to either shrink their balance sheet or consider selling the business and deploying their funds in a more profitable venture.
Strategic management of accounts receivables and payables can lead to an offsetting effect, minimizing the working capital needed to run the business. In case of inventory, or equipment used in the business it might be wise to get rid of redundant assets, so that the amount invested in running the business is as low as possible leading to much higher return on the business investment.
Typically, when calculating the need for working capital, the buyer or their accountant or their banker would like to calculate average working capital deployed in the business on monthly or quarterly basis over the period of last 12 to 36 months. Hence anybody thinking of selling the business should preferably start to manage the working capital well in advance before they decide to sell their business.
The question remains: should working capital be included in the sale price? At N3 Business Advisors, we always advocate for transparency. Before finalizing the Letter of Intent, the buyer’s expected working capital inclusion should be clearly stated. If the seller opts not to include any working capital, it should be mentioned as ZERO in the LOI. We believe this would lead to transparency and clarity as to who is getting what when the transaction is going to be completed.
Many times, buyers come to us with a complicated formula as to how to calculate working capital that would be determined around the closing period. We in most cases suggest that the formula should be removed and precise number should be put in the LOI, in which case if at the time of closing the actual working capital is higher than the agreed upon amount in the LOI, then the additional money should be kept by the seller and if the actual working capital is lower that what was stated in the LOI, then the sale price should be decreased by the same amount. In the end it’s all about keeping the transaction as transparent as possible. So that there are no surprises that can lead to the deal falling apart.
Mastering Your Finances for a Successful Business Sale
Absolutely, let’s dive into why potential buyers are so curious about examining your finances when you’re selling your business. This is a critical aspect of the process, and understanding it can greatly enhance your chances of a successful sale.
Imagine you’re about to buy a car. You’d want to make sure it’s been well-maintained, right? The same principle applies to buying a business. Buyers want assurance that the business they’re acquiring is financially stable and won’t lead them into a financial difficulty soon after the purchase.
So, how do you make sure your business’s financials are in tip-top shape?
One key area to focus on is your inventory. Think of it like cleaning out your wardrobe. If you’re holding onto items, you don’t really need, they’re just taking up valuable space. Similarly, excess inventory holds your money and can raise concerns for prospective buyers. Managing your inventory is the only way to show that you are using your resources wisely.
Now, let’s talk about outstanding invoices. If someone owes you money, it’s only fair that they pay up, right? The same principle applies to your business. Unpaid invoices can raise a red flag for potential buyers. They might wonder why these payments haven’t come through yet. So, it’s important to stay on top of this. Paying off your debts on time not only shows strong financial management but also builds trust with prospective buyers.
Always remember, transparency and good financial practices go a long way in reassuring buyers that they’re making the best decision by buying your business. It’s like laying a solid foundation for a new owner to build upon.
Determining working capital requirements:
What is the most important aspect about working capital? The amount of working capital. How to figure out the perfect amount of working capital for your business. It’s like trying to find the perfect recipe – there’s no one-size-fits-all. It all depends on what’s cooking in your business’s pot. So, how do you find that accurate ratio?
In one of our recent conversations with a buyer who was looking to buy a construction company was eager to understand about the requirement of working capital for a month, where current assets-current liabilities are valued around $700k.
So, how to calculate this?
To ascertain one month of working capital, you’d need to understand the monthly operating expenses of the business. This would typically include costs such as salaries, utilities, rent, and other overheads. Once the monthly operating expenses are known, you’d be able to better understand how much of it would be required to cover a month’s worth of operational costs. “Current Assets – Current Liabilities” could represent more than one month’s working capital. The working capital of a business is designed to cover its short-term obligations for a specific duration, which may extend beyond a single month, contingent on the business’s operational costs.
To summarize, it’s always better to consider this fact. If your business has been around for a while, start by considering your financial history. Look back over the past year-Are there certain times when your money flows in more than usual, or when it takes a dip? This should be considered as the factor which helps you to finalize the working capital requirements.
On the other hand, if you’re in a fast-growing business, think short-term. It helps you adjust to your business’s rapidly changing the financial needs.
Remember, always keep your working capital accurate – not too much, not too little, but exactly what your business needs to grow.
Fine-Tuning Your Finances
Let’s talk about a crucial aspect of selling your business – adjusting your working capital when you’re nearly at the finish line. This is the point were money matters most. You see, your working capital might not always align with what you initially agreed upon during the sale, and that’s where it gets interesting.
If, your working capital ends up higher than what you have expected, consider it as a sign of excellent financial management. On the other side, if it’s lower than anticipated, don’t worry; there’s a chance the buyer might be expecting some compensation to clear things out.
These adjustments can be the deciding factor in the final purchase price. It’s like a financial balancing act, with both parties trying hard for a deal that makes everyone satisfied. So, remember even if your sale chance was lower in the initial time, don’t worry, there is a final lap where your working capital can play a crucial role in sealing the deal.
Now, picture this: a “true-up” period, usually happening 90 to 120 days after the deal is closed. During this time, the final working capital calculations get a thorough check-up, just like your final exam grades. They’re compared to the initial goal. Then, depending on the differences, they fine-tune the purchase price. It’s like the grand finale of your business sale, where everything comes together for the grand performance.
Why Working Capital is important in Business Valuation?
Now coming back to the major and the important topic which needs to be given ample priority as this helps you to sell your business at the right value.
When it comes to valuing a business, as mentioned earlier also, think of working capital as the powerful ingredient that can make or break the deal. Working capital plays a vital role in determining a business’s value, and overlooking it can result in an undervaluation of your business.
Imagine you’re selling a delicious cake, and the sweetness (working capital) is what makes it so interesting. If you reduce the sugar (working capital) or use too much, the cake (business) won’t be as tasty (valuable) as it could be. Finding the perfect balance is the key, just like in your favourite cake recipe.
Valuation Question: So, what’s the right balance for working capital in a business?
The answer is that, it completely depends on various factors, including the type of business and industry. Ideally, you want enough working capital to keep things running smoothly without tying up excessive funds. A professional valuation expert can help you determine the right amount for your specific business, ensuring your cake is just as sweet as it should be, not over or under valued.
Coming to the major part of this, the tax implication. The good news is that including working capital typically doesn’t stir up any tax surprises. Here’s is how: inventory is valued at its cost, and accounts receivable follow standard accounting procedures. So, we can take this easy, no need to build up the tension.
Responsibility of Advisors
Business advisors should play a pivotal role in educating both buyers and sellers about the importance of working capital. Buyers, in particular, need to understand the capital required to run the business seamlessly. It’s all about making well-informed decisions.
N3 business Advisors: your trusted partner:
N3 business advisors aren’t just facilitators; we aspire to be your trusted partner. Our job is to help our clients navigate the risky domain of working capital, ensuring they make decisions that are in their best interest. Our specialty is unlocking the potential in the construction industry, and we’re here to make your business goals a reality. Whether you’re looking to sell, buy, or understand the true value of your construction business, our dedicated team has you covered.
Alright, now you’ve got the inside story on working capital in business sales. Remember, it’s not just a figure on your balance sheet. It’s like the heartbeat of your business, and knowing it well can make all the difference in a successful sale.
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Any information provided here is for information purpose only. It should not be considered as legal, accounting or tax advice. Prior to making any decisions, it’s the responsibility of the reader to consult their accountant and lawyer. N3 Business Advisors and its representatives declaims any responsibilities for actions taken by the reader without appropriate professional consultation.