A crucial red flag when evaluating a new acquisition target is a lack of customer…
The sale (or purchase) price of a company, in most instances, implies that a business is being sold as a “going-concern” to a buyer. Therefore, as part of any sale, a seller needs to deliver to a buyer all the assets (tangible and intangible) necessary to operate the business as a going-concern. Working capital is a large part of any company’s assets and is the life blood that allows a business to operate. Whether a transaction is an asset or stock sale, working capital is always included in any valuation and sale, and must be delivered at the time of closing. A seller cannot operate a business without working capital, so why would a seller try to sell a business as a going-concern and not provide the working capital?
Many sellers believe accounts receivable, inventory, customer deposits, security deposits, and other assets belong to them because it is “their money” they made, invested or reinvested into the business, and hence, the buyer should pay them for these assets. However, these assets are part of the capitalization of a business and are the reasons why a company can generate the products, services, quality and delivery that customers value. This value is reflected in the earnings of a business which determines its valuation and sale price. Thus, working capital is symbiotic with the sale price. Any seller asking to be paid for these assets is attempting to double dip on valuation.
Some sellers also claim that buyers should pay them for some of their working capital because it is bloated (higher than necessary) due to their management style, comfort level, lack of need for excess cash, unique market conditions, or lack of sophistication. These claims are difficult to verify or substantiate. If a buyer is able to operate a business differently post-closing that requires less working capital and frees up cash, then that is the risk and return for the buyer to realize, not the seller to gain. Remember, the seller had years to manage the working capital differently. Once again, the seller is attempting to double dip on valuation.
In summary, buyers want an average amount of working capital necessary to operate a business on a daily basis, based on a company’s historical operating procedures and practices. A business needs to operate the same way the day after closing as it did the day prior to closing. A simple calculation of the average monthly working capital for each of the last twelve months is all that is needed. Occasionally, there are anomalies that can skew the average, but these are extremely obvious and can be considered.