Selling your business? What working capital will you need in the business on the day of sale?

Selling your business? What working capital will you need in the business on the day of sale?

If you are looking to sell your business, you will need to be prepared for the negotiations in relation to what Working Capital (WC) will need to be in the company on the day of sale. Any amounts higher or lower than this “target” WC on settlement date will mean the sale price will be affected.

Negotiations between purchasers and sellers of businesses will usually centre around a company’s earnings (usually Earnings before interest, tax, depreciation and amortisation (EBITDA)) which are then multiplied by an agreed multiple to come up with a value for the business. Purchasers will usually require some level of normalized WC to be included in the company as part of this valuation. WC is crucial to the ongoing trading of the business and is an important part of the assets that the purchaser expects to be on hand when he takes over.

When a business in sold it is common for the valuation to be done on the basis that the purchase price is calculated on a “cash free, debt free” basis. This means that the valuation includes all the assets of the company except any cash in the company. The seller would then need to either pay all the cash out of the company prior to settlement of the sale, as a dividend so the assets do not include any cash. If excess cash was left in the company on settlement day the price paid for the business would likely increase to take into account the extra assets (ie cash) included in the balance sheet over an above the assets included in the valuation.

In relation to “debt free” this means that the purchaser is not taking over any loan liabilities (eg bank debt, lease liabilities, overdrafts or loans due to the owners) when he takes over the company. The valuation of the company was done on the basis that the seller would pay off those liabilities before the purchaser took over the company on settlement day. If there are debt liabilities on the balance sheet at settlement date, they will need to be paid off by the seller prior to settlement or the purchase price is decreased to take this into account. Please note debt does not include all the usual liabilities of a business like trade creditors, tax liabilities, superannuation and general liabilities. Employee provisions can be included in the WC calculation or left out depending on the negotiation and the purchaser’s intention on what employees he intends to take on.

So, this leads us onto WC – what is WC and what is the purchaser’s expectation on settlement day? Taking into account the “cash free debt free” basis of most company sales, the WC calculation will usually be:

  • Current assets (not including cash like assets) less;
  • Current liabilities (not including any debt).

There will usually be a definition in the sale contract which sets out exactly what the WC includes. The contract will usually have what is commonly called a “target working capital”. This is the amount that is expected to be on the balance sheet at date of settlement (keeping in mind there can sometimes be months between date of exchange of contracts and date of settlement). If, on date of settlement, the actual WC is lower than the target, then the sale price will be reduced by the difference. If the actual WC is higher than the target, then the sale price will be increased by the difference.

At settlement date there is a process commonly called a “true up” where the actual WC is calculated based on the formula set down in the sale contract, and the actual WC is compared to the “target” WC. Any differences between the actual WC and the target WC will then adjust the sale price.

WC can be vastly different for different companies. It is a complex negotiation to come up with the target WC. Businesses can have vastly different WC at different times of the year so this needs to be taken into account when putting the methodology together in the contract. In some cases a 12 month average is used to come up with an average WC as a “target”. There is also a possibility of negative WC. This can be the case where businesses sell for cash upfront or get paid on short terms, while paying for the stock on longer terms with their suppliers. All of this needs to be taken into account when working out what a target WC should be.

There is no perfect answer when it comes to working capital and every deal is different. The above discussion gives you some background on the issues should you be buying or selling a business and, in particular, if you are doing this by acquiring the company that owns the business rather than buying the business out of the company.

If you are planning to buy or sell a business in the near future make sure you talk to us first to look at your specific circumstances.

Kreston Stanley Williamson

Author – Michael Goodrick

*Correct as of 3 February 2022

*Disclaimer – this article has been produced by Kreston Stanley Williamson as a service to its clients and associates. The information contained in the article is of general comment only and is not intended to be advice on any particular matter. Before acting on any areas contained in this article, it is imperative you seek specific advice relating to your particular circumstances. Liability limited by a scheme approved under professional standards legislation.

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