While the definition of working capital is simple to define and monitor over time (current assets minus current liabilities), there are several considerations for business sales. Your Advisors’ experience and preparation can smooth potentially contentious closing disputes.
For most small business sale transactions, working capital is fairly straight forward with the seller retaining accounts receivable, and paying all account payables off on the day of closing. However, there are many exceptions to this simple type of deal structure and many buyers and sellers will opt to include some or all of those current assets and current liabilities in the deal for various reasons.
Even if accounts receivable and accounts payable are not included in the sale, working capital is still an issue for most buyers who need an approximation of necessary operating capital needed to fund the first weeks / months of business. If the buyer isn’t concerned, usually his lender is. The seller’s comfortable checking account balance may be all that is needed for a main street business, or a detailed working capital history may be warranted to provide buyers for more complex businesses. Again, these are usually fairly easy to generate.
One of the components of current assets is inventory, and this almost always has closing implications for both buyers and sellers. Usually, there’s an agreed “normal” amount of inventory that is stipulated in the offer and purchase agreement. The difference between actual inventory on the day of closing and this stipulated amount in the purchase agreement is added or detracted to the purchase price at closing. Any unexpected variance from this stipulated amount will cause someone heartburn. Imagine being the buyer and needing to come up with an unexpected amount of funding at the last minute in the case of more inventory on hand than stipulated in the purchase agreement. Or imagine being the seller and receiving a check significantly less than expected if less the pre-closing inventory check shows less inventory value than expected. Once in awhile we find a seller that tries to help out the buyer by taking advantage of discounts or buying ahead of inventory. It’s always best to communicate with the buyer prior to doing this. Usually, the key is to maintain steady, controlled inventory pre-closing and frequent communications with buyers to prevent surprises.
If account receivables and / or payables are included in the price, the trick is to keep the intended working capital in a neutral area. Neither the buyer nor the seller should “come out ahead” in the deal structure concerning working capital. The working capital calculations should be clearly defined, and the target should be agreed upon. This requires the buyer to have adequate time and information to assess the historical working capital patterns and needs. Determining what the working capital should be is often the most time consuming part of the process, but it is much better to spend this time than to accept a target with unknown consequences.
Both sides need an understanding of the cash impacts at closing, and spend the time to define a fair target for inventory / working capital to minimize closing disputes and for neither party to leave unexpected cash at the table.
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