Working Capital: Why Does it Matter

You are selling your business, and all of your ducks are in a row.  You hired an investment bank, they wrote an investment memorandum, solicited bids, and found a buyer willing to pay you a hefty sum for all of the blood, sweat and tears you invested in the business over the last umpteen years.  You passed all of the tests during due diligence, and are negotiating the finer points of the purchase agreement.  The finish line is in sight.  And now you learn about the working capital peg. 

The working capital target (also known as a “peg” or “true-up”) is an important part of an acquisition where millions of dollars are at stake, is poorly understand by many, and is typically left until later stages of the deal.  Very often, sellers leave significant amounts of money on the table (to the benefit of the buyer) as a result of not understanding and addressing the working capital issue earlier in the acquisition process.  In fact, sellers would be best suited to understand the impact of working capital well before they begin the process of selling their company.  Below I explain the ins and outs of how working capital can have a big impact on how much cash you take home after you sell your business.

What is working capital?

This is not a trick question.  We all generally know what working capital is.  In general, it is a measure of operating liquidity available to a business at a given point in time, and is calculated as current assets less current liabilities.  For practical purposes, there are typically four balance sheet accounts that represent the largest entries: cash, accounts receivable (“A/R”), inventory (“INV”) and accounts payable (“A/P”).  I will dive into further detail on these four accounts, but will touch on other potential areas as well.

Working capital is required to run the day to day operations of a business.  It is as essential to running a business as the employees and physical assets.  While some businesses can operate on negative working capital (current liabilities greater than current assets), such as subscription-based media companies or other firms that require large up-front payments from their customers, most firms have positive working capital requirements that grow along with the business.

Most acquisitions are structured as acquisitions of stock or assets on a cash-free, debt free basis.  In other words, the buyer acquires a business that typically has no financial debt and limited or no cash in the operating account.  Buyers often require that a minimal amount of cash be left in the business so that short term needs can be met without drawing on an interest-bearing revolving facility or potentially delaying vendor payments or payroll.  Net working capital (“NWC”) is working capital less excess cash.