After you have successfully bought a business, you need to have an appropriate amount of working capital to maintain the everyday operations. Working Capital is defined as the amount of cash required to operate a business efficiently.
I think it’s important to note that working capital can be something that your financial due diligence team supports as they’re diving into the financial statements so don’t feel like you need to have this ability to complete a deal.
One of the most common ways acquisitions take place is through asset sales, i.e., the buying entity is acquiring the business’ assets instead of its stock or equity. This kind of asset sale is a debt-free and cash-free transaction in which all cash and debt remains with the seller. In accounting terms, it is calculated as:
Working Capital = Accounts Receivable (invoiced revenue that has not come in) – Accounts Payable (amount billed but not yet paid) + Inventory.
In a stock sale, the buyer purchases the entire legal entity in stocks instead of buying the assets of that legal entity, the working capital is calculated a bit differently:
Working Capital = All Current Assets and Cash – Current Liabilities.
In this article, I will be unfolding the complexities of calculating the working capital and in the process explain why it is crucial for any buyer-seller transactions.
Calculating working capital is not always that simple. Both the buying and selling parties have to agree on the amount of working capital and the formula used for its calculation. Both the parties negotiate to establish a common ground because a company’s working capital often fluctuates from month to month.
Working capital is typically set on a “cash-free, debt-free” basis. This means that the seller keeps the cash and is responsible for any existing debt before the acquisition.
A working capital peg is the baseline working capital that the buyer and the seller agree to after at the end of financial due diligence. In simple terms, it means the amount that should be maintained by the seller on the balance sheet on the date of closing.
Sometimes, while acquiring a business, institutional investments like private equity firms establish a working capital peg that has to be included in the transaction. One of the most common ways by which parties agree on a working capital peg is through this formula:
On the other hand, it does not need to be included in smaller and Main Street transactions. Therefore, you can purchase a company for three times the seller’s discretionary earnings (SDE), and then add AR minus AP plus inventory.
There is no rule book that decides how working capital is included in a deal. Keep the following things in mind when deciding upon the working capital:
While acquiring a company, there are many things you look for, including the seller’s discretionary earnings (SDE) to understand the monetary value of that business, and the industry multiplier to assess the long-term value of the business.
Multiples are usually higher on EBITDA than seller’s discretionary earnings, but they include the working capital. It is a loose, gray area loosely somewhere between $5 million transactions up to $25 million transactions. In these companies, they might receive an offer for five times the EBITDA. In such transactions, the working capital needs to be included.
Working Capital Provides Key Business Insights
Working capital plays a crucial role in the transaction process as it provides key insights into the following:
In summary, there is no textbook rule on how to include working capital. However, both buyers and sellers are recommended to prepare a net working capital analysis while they are thinking of buying or selling their businesses.
Watch Walker as he explains what every buyer needs to know about working capital here: https://youtu.be/0EolqLC5Id4
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