Working Capital: In a business transaction

Working capital plays a key role in business transactions, but how does it impact the final deal? In this episode, we break down what working capital means during a sale, how it affects the seller’s net proceeds, and why it’s a crucial negotiation point. Learn about working capital pegs, true-up periods, and how both parties can protect their interests to ensure a smooth transition. Whether you’re buying or selling, understanding this process can make all the difference.

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TRANSCRIPT:

Welcome to Integrated Insights with ICCG. For more than 30 years, our team has

partnered with small business owners to prepare for and navigate the business

transaction process. Pull up a chair as we share stories and insights from our

experience on all sides of the M &A table. All right, and welcome back. My name is

Michael, I'll be your host today. I'm joined by Grant and Andrew. Today, we're going

to be talking about working capital in action. If you missed our last episode, we

talked all about what is working capital and working capital in a business. Today,

we're going to focus on it within the business transaction. Grant, Andrew,

when in the business transaction do we start the working capital conversation? It's

very early. When we cover it with our clients, it's very early on, the reason is

just because we want to set the tone, we want to set the expectation of what's

going to happen. It does go into the net calculation for what you're going to walk

away with at the end of the day.

I know we'll get into that in a little bit, but at the end you're, you know,

as a seller, you are concerned with what you're gonna walk away with at the end of

the day, not the total purchase price. I mean, you know, there's probably some, hey,

I wanna go brag at the Country Club, but at the end of the day, they are more

concerned about what they're gonna walk away with and the working capital does affect

that. And so we'll kind of walk through that with them pretty early on before we

start marketing the company. And so in that way we can also have them know what to

expect when they start receiving an offer. They know a little bit more of what they

can expect

when reading the offer and when we go over the offer with them. - Yeah, I would

just add to the unique, one of the unique things that we do for clients is

actually before we even sign up them as a client. Because we want to,

I mean, we can assign a ton of clients up and they think they're gonna hundred

million dollars for the company and we know is not worth 50. And and so why would

we sign them up to an exclusive representation to sell their company because we

can't we can't accomplish their goals. So when we take them an offer for 50 million

dollars and they thinking well I'm not gonna take that well it might be what the

market says that business is worth but their expectations are not fulfilled.

And I kind of used a little bit of a hyperbole there. But I think it goes down

to that net net number. We want our client to understand that the value that we

anticipate is going to yield a net that they can accept. And part of that net

includes excess working capital or maybe a deficiency in working capital.

They I gotta leave in the company. And so we gotta include that almost before we

even accept the assignment. So it starts really early. I'm not sure that our clients

understand the way it works until later on in the process when we actually go

through like a, like a And if it closed this month, here's the way it would end

up. And then the more and more we do that, the more and more they understand, "Oh,

that's how it works," and then they understand the purpose of doing it the way we

do it in the transaction.

That's great. So talk about that a little bit more, because some people might be

here in working capital and think that it's a flat number, that that's what they're

going to get because that's what they need to run the business. So how does timing

and where a company is at a specific time affect what working capital will be at

the time of close? Yeah. So let's just talk about how, you know, the biggest, let's

just say you got a seller that is one of our clients and they just think they're

going to work the system. And so what they do is they go out there and they stop

paying their bills and then they hurry up on their collections. They just they just

hard collect on all the clients and they just tickle pink because it's a cashless

purchase and they've got all this cash in the bank and the buyer comes in and he's

got all these bills he has to pay And he's got no accounts receivable to collect.

So he has to put more money into the company in order to operate the company. So

he thinks he's going to work the system. Correspondingly, the buyer is protected

because the seller is on the same page as the buyer. So the seller is not going

to hard collect on clients. So his customers are going to be okay. He's not going

to stop paying vendors, so the vendor relationships are going to be fine.

And so it protects the business. And so the reason why we do this working capital

process that we use is really to protect both parties.

It's not,

a ton. It's not a, let's get one over on the other side scenario.

It is what is fair and it's a win -win. So you protect both parties so that the

business can operate in the way that both the buyer and seller anticipate. So does

the working capital amount affect the sales price or are they exclusive? Now

exclusive. No, the networking capital, which a lot of people call the working capital

peg, is what we all agree on is what comes with the purchase price.

And so let's just talk about that for just a minute.

If I spend $10 million buying a company

And I have to immediately put $2 million into the bank in order to pay payroll,

in order to buy inventory, in order to pay off bills, those kinds of things, then

I really didn't pay $10 million for the company. I pay 12, right? And so when I

pay $10 million for the company, I want sufficient working capital, meaning a counter

-achieveable inventory in the company, in order for the company to go on operating

without me having to put additional $2 million in the company, right? 'Cause I

valued the company at $10 million. And so there's an amount that is appropriate,

let's just say, for the company to keep on running without me having to invest more

money into that company. And we help calculate that. And so just,

you know, maybe there's a pet, maybe there's a little bit of a soapbox here for

me. But a lot of times these buyers will hire an audit firm or some sort of a

test firm that will do a quality of earnings. And they will judge working capital

based on what it always has been. In other words, an average of what you have had

in the company over the last two years. Well, most of our clients have excess

working capital in there. They leave money in the bank and they just don't worry

about taking everything they can out of the company because they don't want to have

to manage cash flow that tightly. And so the idea is to determine exactly what is

necessary. And we have, it's not our way, but it's a common way,

but it's not commonly used by people like us. And that is the way to determine how

much working capital you need for the company to generate itself.

It's kind of like pushing a wheel.

And then as the wheel turns, it kind of generates speed as it goes,

right? So that initial push, how much working capital needs to be in the company to

in order to get the cash generating revenue model to start rolling.

And so we help calculate that. It's a point of negotiation. it's a peg.

It's a number that has to be in the company when we pay a certain amount for that

company. And when we do close, and there's more accounts receivable,

let's say, because they just made a big sale, that accounts receivable, it really

belongs to the seller. And so there's an excess of working capital at the time.

If for example, all of a sudden there's all these receipts that come in the door,

now there's very little account receivable, so they may not be enough in the company

and so the seller needs to leave cash in the company so that the buyer can

continue paying payroll and buying inventory. And so the number, it is a number,

a net number that you agree on, you negotiate for, but it determines how you

reconcile closing. If it's excess, the seller gets more. If it's a deficit,

the seller gets less. Can you talk about a hold back a little bit there? It kind

of transitions right into the same conversation, but how is a hold back used in

deals related to working capital? I'll explain, 'cause I know we recently just had

to kind of deal with that a little bit in a recent deal, because we didn't have a

hold back, we represented the buy side, and the reason why we need to do a hold

back is because it's really for the working capital true up period.

And I know there are other reasons for indemnification, like an indemnity bucket, all

those kind of stuff that we can talk in another time. But for purpose of working

capital, there's got to be some sort of true -up period, right? We can say that,

hey, this is a,

we can say that, okay, it's going to be around around number, $100 ,000,

and as a work capital peg, but we need time to kind of prove that that's the

actual number, right? Because it can't be a moving target. There can be other things

that the seller didn't include in the calculation. And so there needs to be that

time for a true up period so that maybe 60 days 90 days later after closing we

can kind of say okay that's that's that's when there's a that hey we can confirm

that is it is a hundred thousand or maybe it's 110 maybe it's 80 maybe whatever

that you know it's a moving target so whatever that number it lands on at that

time then then that's that's it now I mean we I mean, there's going to be an

agreement before. I guess the PEG is not the one that's moving. It's really working

capital at closing is what's going to move. And so at closing,

the seller delivers a working capital calculation. And they will say, OK,

the PEG was $100 ,000. I've got $120 ,000. Or I've got and and so that that true

up period is okay what was actual and that word in capital closing the buyer does

its due diligence then and then at that time okay we can confirm that it was 150

,000 here's your extra 50 ,000 and so or hey nope that's that was wrong it was

actually 90 ,000 and so you know maybe you know there's a switch there.

So really, it protects both sides so that there's a period of time where the due

diligence can be done. And so we've got to be careful that we don't confuse mixing

the two concepts of holdbacks and working capital true up,

because It is a way that they can satisfy a deficit, but it's not part of the

working capital. In other words, if I agree to pay,

if I'm gonna buy your house, for example,

but I've never seen it, 'cause I live in a different country. And I'm going to pay

you a million dollars now, and then once you move out,

I'm gonna give you another 200 ,000, right? And by the way,

you may not have paid the utility bill, you might have left a big hole in the

ground instead of a toilet, and so I'm gonna use that $200 ,000 to fix those things

because I'm paying $1 ,000 ,000 for your house, right? A business purchase is very

similar to that, is that in a hold -back, 'cause I'm gonna pay you $1 ,000 ,000 for

your business, but I'm gonna hold back $200 case, in case you owe me money,

because I can't go get that money from you without incurring legal fees and all

kinds of stuff. And if I determine that I don't owe you any money, then I'll pay

you the $200 ,000. And so sometimes those holdbacks are, you know,

for a year, sometimes two years. And it's generally less than 20 % of the purchase

price, but that's a holdback. And the reason why it kind of goes along with some

of the settlement of the working capital settlement, or the true up, as Andrew said,

is only because if the seller owes the buyer money,

then they just reduce the holdback. Or sorry if that yeah if the buyer if the

buyer owes a seller money, yeah, they just reduce the the hold back So now some of

our listeners might be thinking, you know, hey, my business is changing all the time

Right, I could get a new deal a new big order any minute. How is working capital?

How's that calculation? Going to be ready for that, right? So what What happens,

Grant, earlier, you were talking about a company could receive a $2 million order

from Target at any time, and so what happens in that situation when a deal is

already occurring in process and a big change happens like that?

Yeah, and this happened with one of our clients who was dealing with SpaceX and he

got a huge order and finish the order off in between cutting a deal

and closing. And so we had to go to the buyer and say, hey, you're gonna have to

have an additional $2 million when you come to the table. And he goes, well,

that's ridiculous. I mean, the value of the company hasn't changed just because you

got a big order, and we said, "Well, our accounts receivable is $2 million more

than the peg, and so you're going to have to bring that to the table." And so

what we did was, is we negotiated a way where he could pay, where the buyer could

pay that $2 million as he received the money from the big client.

You know, there are always these kinds of changes in the business, but you know as

Dave always says bad news doesn't get any better with age. We try to make sure

that that we keep the both of buyer and the seller abreast of what's going on so

that the buyer knows what he's going to have to bring to the table and we can

negotiate and make sure that if he needs additional time to pay that additional

amount if it's reasonable. We'll talk to our client about accepting those terms,

but it is something that business does change. The whole idea is that the buyer is

not cheated and the seller is not cheated. So you just said the buyer is not

cheated, the seller is not cheated and that's like we don't want anyone to take

advantage of anything during the selling process, during the business transaction,

negotiations, any of that. What happens after the deal closes? How does working

capital or yeah, working capital help to protect the buyer and the seller after the

deal closes? Yeah. So, you know, remember, there's a price, at least this is the

way we try to script it. It's, other people handle it differently, we just try to

make it as smooth as possible, no surprises, right? That's what we try to do.

And so, we have previously negotiated that the working capital is a certain amount.

Sometimes, at closing,

we won't settle anything on working capital. Sometimes we say the seller is going to

estimate what those actual balances are and say hey I've got an excess of $100 ,000

and the buyer then has to bring that $100 ,000 to the table at closing.

But the buyer then has 60 days or sometimes 90 days,

depending on the complexity of the accounting process, to determine what it actually

is. And then there is what is commonly called a true up. In other words,

he determines, like after auditing it, what exactly that really was.

So if I'm the seller and I didn't include a big bill that I owed,

then he can include that in his calculation. And then they figure out who owes who,

what? And then there's a true up, and if the seller owes the buyer some money,

or the buyer owes the seller some money, that's when it happens. And there's a, I'm

not gonna say, I nearly said I wasted two pages of legal document, but is a very

complex process that lawyers put together of, okay, what happens if we don't agree,

right? Okay, we can get a mediate, we're gonna hire an accounting firm to do this

and all that kind of stuff. Well, we generally try to mitigate that by stepping in

because we've been dealing with both parties. We know the company really well, and

so we'll try to make them agree before it goes into some sort of arbitration or C

C C C C

liability for PTO. Well, just imagine going into a company,

buying a company in October, and none of the employees have taken vacation.

And you owe all of them two or three weeks worth of vacation. Well,

what am I supposed to do with that? If they all of a sudden all took vacation in

the last three months out of the year, then I don't have any, I mean, I've got to

pay them and I have to buy help. I have to buy temporary help to fill all the

desks, right? Or if it's a retail place. And so it's the same thing.

It's like, you know, we always ahead of time, we say, hey, there is a liability

that you don't normally put on your balance sheet and it's called a crude PTO.

So Let's try to calculate that so we can prepare you because once they calculate

working capital, they're going to include that in the working capital calculation.

So don't be surprised. And we've already, now we can argue whether that includes

payroll taxes or whether that includes this and this, it's a minuscule amount. The

idea is, is we prepare our clients so that there are no surprises. We can agree on

what it is. And you know, if you incurred the bill, then you got to pay the bill.

If you didn't incur the bill, you don't have to pay the bill. And so it's not

quite a science. But if you prepare your clients ahead of time, as well as the

other side, it's a very smooth process. But yes, we do work with our clients after

closing to make sure their interests are guarded.

So I know we have tons of stories for more than 30 years of doing this. So are

there any other stories that come to mind of just we're working capital played into

our impact on how we're able to help a client through a business transaction? Yeah,

I feel I mean, the way that we help our clients is taking a lot of that

conversation because the conversation has to happen about work capital.

And if you don't understand it, it's really hard to negotiate it because it is

another point of negotiation. And so we have to take that on and make sure that

our, to be honest, a lot of our clients just won't understand it because I mean,

you, you, I think you joke, but it might be serious that you, you explain to a

client maybe 25 times what working capital is and, and I know I've done the same

thing and, and at the, but at the end of the day, um, if they trust, I mean,

they need to trust us, right? And, and, uh, and we're going to, uh,

make sure that they're they're taken care of. And so we take care of them by

taking that conversation and we negotiate for them what that word capital peg is,

the script of how it's gonna be paid, the script of, yeah,

just how to write it in the purchase agreement. And because at the end of the day,

if you don't, if we don't help them with that, I mean,

sellers can be taken advantage of and much like Grant said earlier is that sellers

might try to take advantage of the system and then it's a big surprise later and

so we have to, and we help them by saying, "Hey, don't do that," you know, because

it's going to hurt you in the long run because you're going to be surprised that,

"Oh, you've collected so much and not paid any of your bills and so you're gonna

have to owe and it's just a surprise for them. And we just have to,

we serve them by taking that conversation on. And so it's,

'cause it can be a difficult one and it is a, I mean, working capital itself in

that negotiation can be a deal -killer just because it's almost like a convoluted

conversation, right? Yeah. And how many times, you talk about deal -killer,

a lot of deals are killed because a seller doesn't understand and they don't want

to Understand and it becomes at this point. There's a lot of fatigue And if you

don't deal with it up front then all of a sudden there's some really important

things and so You know expectations are super important to meet and so how many

times have we? You know talk to a seller and the seller goes no the counter seable

is mine. I earned it, I earned it, right? You know,

I'll pay all the bills, but the account receivable is mine. Okay, so let's just

walk through the consequences of that, right? So you're gonna keep the account

receivable. I'm buying your company. You're gonna hard collect on my clients.

Why would I want to buy a business and you still have control over the clients.

There's no way. Correspondingly, if I collect the accounts of Siebel and I have to

pay it to you, I'm going to give them all discounts on your invoices while I

collect 100 % of my own invoices, right? And so it's just,

you know, we just, we have to remove the possibility of mistrust and make it fair

and meet expectations. And so when we talk about expectations with our clients and a

sell side, we're making sure they understand exactly what levers they can pull to

move the sales price up and down and what layers they cannot pull at levers.

And So it's all about meeting expectations, and working capital is hard to

understand. And so expectations are difficult to convey. And that's why we end up

going, okay, you're going to get this a much net, net, net. And it's more than the

sales price because of the way you've operated your business. And this is how it's

going to get paid. And that's how we deal with working capital. Well, working or

sorry, repetition is important, right? So if this being the first subject that we've

done two episodes on shows you anything, it's that we're trying to communicate that

working capital is important. And if you've been tracking with us so far, you you

can see now that like we've talked how much we've talked about trends and

consistency and consistency, and how important working capital is in both your

business and the business transaction conversation. So if you're still thinking like,

"Hey, you've given a lot of great examples, guys." But none of those really sound

like my business. We'd love to sit down with you. We'd love to sit down and talk

and help you to know what that looks like in your business, and what that looks

like as you try to decide if it's time for you to prepare for a sale yourself. So

make sure to send us an email. Grant, Andrew, thanks for joining me today. That's

all the time we got. - And that wraps up another episode of Integrated Insights with

ICCG. Be sure to subscribe and stay tuned for more stories from our team. We love

hearing from our listeners. If you have any questions or topics you'd like us to

cover, please send us an email in the show notes. For more information about ICCG,

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time, there's always a seat at our table.