Working capital is the most common reason the price agreed in negotiation differs from the amount that reaches your account. The buyer assumes they are taking over a business with a normal level of stock and receivables. If there is less of it on the closing date, the price drops by the difference. The definition of “normal” is negotiable, and it needs settling at the letter of intent stage, not in the sale agreement.
What this is actually about
The price is usually agreed as enterprise value. To get to the amount paid for the shares, net debt is deducted and an adjustment made for the gap between actual and normal working capital.
The logic is simple. The buyer is paying for a business that runs. A running business needs stock, has money owed by customers and owes money to suppliers. If it arrives with an empty warehouse and receivables already collected, the buyer has to put cash in to get it back to normal. So they want the price reduced by that amount.
Where the normal level comes from
Usually from a twelve-month average before the transaction. That looks neutral but has two weaknesses. In a seasonal business the average says nothing about how much working capital is needed in the particular month of closing. And if the business has been growing, a twelve-month average is lower than today’s real requirement, which works in your favour, and the buyer will usually spot it.
It is worth calculating your own normal level before the buyer does, with the reasoning ready: seasonality, stock turnover, payment terms of the largest customers.
The most common seller mistakes
- Optimising before closing. Holding back purchases and chasing collections raises cash but lowers working capital. The net effect for you is nil, sometimes worse, because the buyer notices and raises the normal level.
- Treating overdue receivables as healthy. The buyer will exclude them. Better to do it yourself and show you have control of your data.
- No agreed definition. If the agreement does not list which items fall inside working capital, a dispute after closing is close to certain.
- Mixing it with debt. Factoring, customer prepayments and shareholder loans get counted now here, now there. Each of them has to be assigned unambiguously.
Locked box as an alternative
Under a locked box, the price is set from a balance sheet at a fixed past date and is not adjusted after closing. You know the amount up front, the buyer takes the risk of movements after that date, and in exchange expects a ban on value leaving the business in the interim. For a seller this is usually more comfortable than completion accounts, provided the business is stable.
See also
- Net working capital - definition, formula and the normal level
- Locked box versus completion accounts - two pricing mechanisms
- Red flags, where working capital is the seventh of twelve areas
- Price chipping, on what else cuts the price after the review
About the author
Łukasz Brzyski runs Brzyski & Partners Management Consulting. He advises on the sale and purchase of companies valued between PLN 10 and 50 million, and sold two companies he co-founded before he started advising others. More about the author