Working capital is the capital (cash investment) that is needed to fund the everyday operations of a business. The amount of working capital a business requires will generally, but not always, increase as the business grows.
Good management of working capital doesn’t just help with cash flow optimisation, it can also have a material impact on the net proceeds received from the sale of a business.
How working capital affects transaction price
During the sale of a business, the buyer and seller will often have very different views on how much working capital is required.
The buyer will want to make sure that there is sufficient working capital left in the business to enable them to continue to trade, without the need to make available additional funding to meet items such as trade creditor payments, VAT payments, seasonal trading peaks and potential mid-month funding peaks.
For the seller, the lower the amount of working capital left in the business, the higher their net proceeds will be, as a result of maximising the surplus cash / minimising the net debt to be repaid.
To avoid disputes, it is best to negotiate a target working capital amount that is acceptable to both parties. This amount is then documented in the sale agreement, alongside what is to be included and excluded in the calculation of working capital. This negotiation is often complex, and poorly advised sellers can easily give value away without even being fully aware they are doing so.
As it can take months to complete the sale of a business, the target is then compared to either the actual amount of working capital on the completion date (via a completion account mechanism) or to an amount on a date shortly before completion (the locked box mechanism).
Taking the time to understand properly how the working capital adjustment will impact your net proceeds is essential if you are to maximise the net sale proceeds.
Optimising working capital negotiations
1. Working Capital Target
To calculate the working capital target, you should carry out a comprehensive analysis of the business’s historic working capital. Looking at working capital over an extended time frame will allow you to work out the most and least favourable outcomes before you enter into negotiations.
If your businesses relies on seasonal sales periods, the timing of a sale could make a dramatic difference to the amount of working capital. You should keep this in mind when you begin to negotiate a settlement date. Buyers will also be suspicious if the typical debtor and creditor days change in the months prior to a sale, and are likely to argue that this needs to be adjusted for. Minimising working capital well in advance of any process is therefore critical.
3. Defining Working Capital
You should work closely with your financial and legal advisors to agree clear definitions of working capital with the buyer. Imprecise definitions can lead to disputes further into the sales process, which often involve large amounts of money and can even lead to deals collapsing.
4. Professional Advice
A badly negotiated working capital adjustment can have a severe negative impact on the sale of a business. Seeking advice from an experienced corporate finance advisor when negotiating the working capital adjustment can offer you peace of mind – and ensure you get the best outcome from the sale of your business. Working capital is usually included as a key term in any offer letter or heads of agreement, meaning it is essential to get this advice very early in any potential sales process.
By Hamish Morrison
Partner, BHP Corporate Finance