How Working Capital Can Kill or Save A Deal
If you’re a successful business owner, you have a good understanding of working capital and a firm grasp of your company’s working capital. As such, you’ve strategically utilized your working capital to grow and expand your company over many years, and you’re now ready to initiate your exit strategy. During this phase, research and crunch many numbers from your financials to create a valuation. After multiple calculations, you’ve determined that the valuation for your company in the current market is $10 to $11 million. After giving some thought, you decide to list your company for $9 Million in hopes of a quicker exit, as you’ve just received news of being a grandparent. You think this deal will likely be quick and easy as you’re selling a very profitable company below market price. So how can working capital kill a deal such as this? First, we need to elaborate on working capital to ensure we’re on the same page.
Defining Working Capital
What exactly is working capital? Working capital can be described as the funds you need to operate your business on a day-to-day basis. Many people also define it in its simplest form as the company’s current assets minus its current liabilities. It’s important not to confuse the company’s total assets or liabilities and focus only on its current assets and liabilities. If you’re wondering what’s considered current assets and liabilities, you can think of the word current as one year or less. To be regarded as a current asset, it must be an asset that can be converted into cash within one year or less, such as accounts receivable, inventory, marketable securities, etc. Current liabilities will usually consist of short-term debt such as accounts payable, payroll taxes, credit cards, etc. All these assets and liabilities are derived from a company’s balance sheet. A balance sheet is a financial statement that lists the company’s assets, liabilities, and equities for the given date.
By looking at a company’s balance sheet, you can calculate its working capital by taking its current assets and subtracting its current liabilities. When there is an excess of current assets after deducting the current liabilities, the company’s working capital is positive, whereas if the current liabilities outweigh the current assets, the company’s working capital is negative.
Why Working Capital is Important
We mentioned needing working capital to operate a business on a day-to-day basis. Without working capital, businesses wouldn’t be able to pay their utility bills, employees, purchase inventory, etc. Working capital can also be used to measure a company’s operational efficiency and short-term financial health. A company could invest in expansion and growth if it has substantial positive working capital. It’s also important to note that just because a company’s working capital is negative, it doesn’t mean it is in financial trouble, as some industries’ working capital is negative in nature. The company’s working capital will typically depend on its industry. Some sectors, such as manufacturing, with longer production cycles, may require higher working capital as they don’t have the quick inventory turnover to generate cash on demand. Alternatively, retail companies that interact with thousands of customers daily can often raise short-term funds much faster and require lower working capital requirements.
Now that we’ve reviewed working capital let’s put it into perspective with an example of how it can kill a deal when it’s not applied correctly.
Let’s refer to the beginning when you calculated your company’s valuation at $10 to $11 Million. Shortly after you list your company for $9 Million, you receive an offer for your company for the asking price of $9 Million, and both you and the Buyer sign an Asset Purchase Agreement. Everything seems to be moving smoothly; the Buyer’s been approved for the loan, the due diligence has been complete, and you’re just waiting on the closing date to sign the dotted line. Few days to closing, the buyer inquired about working capital requirements as so he could continue operations without any interruptions but was shocked to hear an amount of $2 Million. This moment was when the deal started to sour, as there wasn’t any language in the Asset Purchase Agreement about the inclusion of funds for working capital for the purchase price of $9 Million. As your company requires about $2 Million in working capital, you and the Buyer will now have to renegotiate the Asset Purchase Agreement and the possibility of the deal falling through. This situation is not favorable for you as the Seller since the Buyer has already gained much confidential information about your company, leaving you more vulnerable.
Miscalculations of Working Capital
While working capital plays a role as a financial measuring tool for businesses, it can play a prominent role in M&A transactions compared to Main Street. For small businesses or companies categorized in LMM (Lower-Middle-Market) and higher, calculating working capital can be much more different as the formula will be dictated by the asset or stock purchase agreements. In some M&A transactions, working capital may involve cash or debt in the working capital calculation, while other transactions may exclude certain assets or liabilities. These calculations impact the Seller on a spectrum that varies and will be determined within the Purchase Price or working capital section of the stock or asset purchase agreement. Once the working capital has been determined, a target date will be set, and the company’s operations before closing can drastically impact the funds a seller receives at closing. Let’s look at another example of how a deal can go sideways when working capital isn’t applied correctly.
Let’s use the same example from Scenario 1, but we’ll include the language for working capital funds in the Asset Purchase Agreement. In this scenario, let’s say you are selling a building materials company for $9 Million, which includes $2 Million in working capital. You and the Buyer signed the Asset Purchase Agreement in October and agreed on a closing date set for January. However, your company’s been struggling to keep inventory in stock, and the cost of goods continues to rise due to recent global supply chain disruptions and decides to purchase extra inventory in the amount of $700,000 in December. At the time of closing, your company’s working capital is close to $3 Million due to the extra purchase of $700,000 in inventory, but as there was no language about excess working capital, $700,000 of your proceeds is in jeopardy. If the Asset Purchase Agreement had included the working capital language of an asset purchase agreement stating, “a purchase price of $9,000,000 minus the amount by which the Working Capital as of the Closing Date varies from the six-month trailing average of the Working Capital.” The calculation methodology used for the working capital will then be described in the asset purchase agreement, and a working capital target is set by a twelve-month average trailing the closing date. At closing, if the working capital exceeds the average monthly working capital balance for the twelve months before the closing, you would’ve walked away with more funds.
Get a Second Look
The examples are just a few ways a deal can go sideways during M&A transactions. For business owners, a well-planned utilization of working capital can help accelerate their exit strategy and increase the valuation and amount they receive at closing. Although working capital can be simple to calculate at its basic formula, applying it to a company can become very complex in M&A transactions. Having a professional M&A Advisor like V-AID Business Investment take a second look at your working capital can help you better plan your exit strategy.
Since 2001, V-AID Business Investment, a team of resilient business brokers and M&A advisors in Dallas, TX, has been specializing in selling small to mid-size businesses in the main street to the lower middle market. V-AID’s experienced team of experts has a proven strategy that will ensure strict confidentiality, a streamlined selling process, and the maximum value for the business. With deep expertise accumulated from hundreds of done deals, V-AID delivers superior results by providing clients with strategic planning and creative solutions tailored to each transaction. Combining V-AID’s proprietary database of buyer networks and industry-leading marketing, V-AID offers a proven selling method that has been the solution to a value-added exit for hundreds of business owners with a completion of 585 transactions totaling over 124 Million Dollars and continuing.