Entrepreneurs looking to optimize their sales price when they’re ready to sell their business generally realize the importance of such factors as timing, market comps and buyer suitability as they make these emotionally and financially complex decisions. You’ve poured your heart and soul into building a business, so making sure you land at a fair price is essential when you’re ready to move on.
Business sellers tend to be earnings-focused when setting a sale price, maximizing the EBITDA multiple they can receive from a buyer. They may also highlight net revenue and growth potential to a motivated buyer as top selling points in the valuation of a business.
But determining value is not as simple as stating the sale price should be five times your company’s earnings. The importance of a business’s cash flow, and specifically the role of working capital, is sometimes missed as a critical factor over the course of the transaction.
If your liquid assets (minus obligations like accounts payable to vendors) fall short of what’s needed to run the business in a given month, you’ll likely have to lower your sales price to attract a buyer who’ll have to pony up more of their own funds when they take it over.
Working capital variations
Keep in mind that that the proper amount of working capital varies widely depending on the nature of the business. An aerospace company needs far more working capital because of the high costs of building a single plane, than, say, an insurance company. It will be a long time until the aerospace company gets paid for the plane they’re building. A service business or one that needs relatively little physical inventory to generate its revenue requires much less working capital.
In their due diligence, a buyer is likely to have advisors examining the business’s history of working capital and determining the level necessary for running the business going forward, while comparing it with the seller’s calculation in the sales presentation.
If a company turns out to have less working capital than expected after the buyer’s analysis, its purchase price will likely be lowered at the negotiating table as the buyer will likely have to account for that shortfall. For example, if the working capital is short by $1 million, the buyer will seek $1 million off the purchase price since the new owners will have to come up with that amount to keep the business going.
By the same token, if there’s excess working capital in the business, the price goes up.
Here are four ways that working capital comes into play in the lead up to selling a business, or at the negotiating table once the transaction is underway. These factors can affect the calculation of your business’s value more than you may realize:
1. The costs of growth
If you want to grow your business before you sell, this decision will probably come at the expense of your working capital. Your working capital needs may increase more than you anticipated to increase your revenue.
2. Missing accruals
During due diligence, it’s not uncommon for buyers to spot certain expenses that weren’t recorded properly like vacation pay, payroll bonuses or even medical claims. Those costs drive up liabilities, which decreases your working capital. The working capital you think you have may be inaccurate if you’re not up to date in tracking your accruals.
3. Insufficient inventory reserves
From a buyer’s perspective, they want to ensure there is adequate inventory on hand to support sales growth. Through due diligence, a buyer will be able to determine if a seller has kept inventory past obsolescence, resulting in the company presenting a stronger picture for liquidity in operations though manipulating working capital and inventory.
4. Special terms applicable only to seller
A business may have had concessions from vendors, like a more generous timetable for payable accounts than may be extended to the buyer who comes in later. These terms allowed the existing owner to carry on business with deficient working capital. Or a business may have gotten a discount from a vendor for paying early, enabling them to keep lower working capital on hand than is typical for that industry.
A new owner can’t count on receiving those beneficial terms, which must be factored into a more realistic calculation of the business’s needed working capital going forward — and likely a lower sales price.
How Wipfli can help
Managing the cash inflows and outflows for every business is different and needs to be carefully evaluated when buying or selling a business. Wipfli advisors can help buyers and sellers through all the steps of the sales process, highlighting the various factors impacting working capital and how they have a significant impact on the valuation of a company. Reach out to learn more.
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