Working Capital: Seller FAQs

In this episode, we revisit the topic of working capital diving into the complexities. We answer common objections about how working capital impacts the value of your business and explore ways to ensure a fair deal for both buyers and sellers. If you're considering buying or selling a business in the next few years, this discussion will help you better understand how working capital can affect your transaction answering some of your questions before you need to ask them.

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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 to another

podcast episode. My name is Michael Hefner. I will be your host again today.

I am joined by Grant McQuilkin, one of the founders of ICCG. Hi, Grant. Good

morning, Michael. Morning. So today, we're going to be revisiting the topic of

working capital. So if you missed them, we did do a couple previous episodes on

working capital, both what it looks like in business as well as working capital and

action and what it can look like in a deal. But we have a lot of business owners

that even after those explanations, they still come and they just have additional

questions. So today on this episode, I'm gonna do a little bit of role -playing. I'm

gonna be that business owner that still has some more questions. I'm gonna be

directing them to Grant. So, Grant, to get started,

I've worked really hard, right? I've built up my AR, I've earned that AR.

I hear you saying that I don't get to keep that. Can I just pay the accounts

payable and keep that AR that I've built up? Yeah, sure.

You can, but you have to be careful what you ask for because, you know,

you don't have any leverage. So let's just say you sell your business and now

you're to go start collecting that account receivable. Typically one of the factors

that you can use when you are collecting your account receivable is you can just

stop working for that customer until they pay. But in this case,

you've already sold the business. The buyer is going to continue working for that

customer and is going to get paid on time because they don't want him to stop

serving them. And so you lose all your leverage. It's not like you can sue for it

because it's going to probably cost you as much to get that account receivable paid

as it does to sue. So, you know, also the buyer doesn't want you to control that

relationship with his now relationship, right? And so he doesn't want you to go cuss

him out for not paying their bill. He wants to run that relationship.

And we've seen hybrids. We've seen to where the seller insists on getting that money

and wants to pay all of the bills. And so the working capital sort of normal

process is kind of, especially in smaller deals, it's kind of cut off because the

new, the sellers or the buyers don't really understand it. And so what we do is we

have the buyer actually collect the funds and as long as they collect the funds,

then they transfer maybe a large percentage or sometimes all of it over the seller.

The danger with that is, is if I'm the buyer, I'm going to my customer and saying,

"Hey, I'll give you 60 % off of your past bills if you commit to buying X amount

over the next year." I mean, you just lose control.

That's why we have our process of making sure it's fair to where neither the buyer

nor the seller can rig the process to their benefit. That's why we do that.

Working capital is an asset of the business that you're selling. That's kind of like

saying, "Well, I'm going to sell the business, but I'm going to exclude all of the

equipment." Well, how in the world is somebody going to run the business without the

equipment that's necessary to run it and so you've got so many you know analogies

we've used in the past we like the analogy of the car you when you buy a car and

it doesn't have any tires you got to go buy tires and then use the car so when

you buy the car you're going to pay less for the car than you would have if there

were tires on the car and And so the point is working capital, a measure of

working capital is one of the assets in the business that you purchased for a

particular price based on the value of that business, including the equipment,

but including also a reasonable level of working capital that generally allows the

buyer to not have to invest more money in the business after he's paid you the

purchase price. Yeah. Yeah. That's great. I like that you quickly brought in the

customer into the conversation, right? Because that's really what it all comes down

to. Because if they get to keep the AR, that's not just money they get to keep,

right? It still has to be collected, so the buyer could just not collect it. So

it's like, "Hey, sure, you can have the AR, but you're not going to get paid

almost any of it, right? And on the flip side, it's just not fair for them to go

and quit collect, right? And mistreat those customers and then lose them all. So

that's great. Makes a lot of sense. So you just talked about the car analogy again

that we brought up previously. And so the tires on that car or the gas can be

seen as inventory, right? So the buyers that are business owners that have that

inventory that's been built up, but they haven't been accounting for it. And so if

I've built up my inventory, how do I get credit for that? - Yeah, you don't unless

you have accounted for it, right? And so there's various different kinds of

inventory, right? So we often see this as supplies. And the reason why is because

you're small to medium -sized businesses out there, They don't want to tell the IRS

they have inventory. The reason why they don't want to tell them an inventory is

because they don't want to be a cruel basis taxpayers. And so all that to say,

sometimes there's a level of supplies that are there. It's just not on the financial

statements or tax returns for tax purposes. And so what is called de minimis,

It's only a little bit, but $100 ,000 worth of supplies is worth trying to get

reimbursed for that $100 ,000. The idea is to make sure that you get to that real

quick in your conversations with a potential buyer. You don't want any surprises in

in the last minute, all of a sudden you do this, you know, working capital

calculation as $100 ,000 worth of supplies on it. I think the other side to it is

that, you know, some inventory is,

you know, what you manufacture. And so typically, if you're doing that,

there is inventory that is kind of in the process of being made. And I would say

most of your small to medium -sized businesses don't have the sophistication of the

accounting system to calculate that correctly. Sometimes they'll do the materials cost,

but the labor is kind of complex. And so they don't capitalize labor.

I think that is something also that is important for the advisor to understand so

that you deal with that upfront with a potential buyer. Because if it's a buyer

that is sophisticated, they'll understand, they'll just have to recast those financial

statements going back a little bit in order to know exactly how that work and

process affects the bottom line. I think we faced a lot of issues with long -term

construction contracts. So those are really difficult because it's not just work and

process inventory, but there's a percentage completion calculation that not only gives

you work and process, but it also makes you recognize a little bit of income as

you go along in the long -term contract and so That's that involves estimates that

if you don't if you don't give time after the deal is closed to Validate those

estimates. There's been some lawsuits funded through a a manipulation of those

estimates and that all kind of goes into sort of an inventory but more in a

construction contract. Yeah. That's great. And as far as the working capital and

getting compensated for that $100 ,000 like you talked about, that's talking about

like excess working capital, right? $100 ,000 more than what you needed? Yeah. I

mean, but a lot at times is $100 ,000 worth of supplies and it's never been part

of the financial statements. It's just been written off as they maintain it and a

lot of times it's like you buy it one time and then you just replacing because

you're using the same supplies. Think of a medical facility, it's just $100 ,000

worth of medical supplies and so they order as they use,

so to speak, but they're just expensing it at the time. They're not capitalizing it

on the balance sheet, so it doesn't look like working capital, but it certainly is.

That's great. So what about cash? So if cash goes into the working capital

calculation, why don't I just wipe out my bank account right before I close? Can I

do that?

Most of our are, they say on an LOI, it's a cashless asset purchase,

let's say, but this assumes that you have an acceptable level of working capital,

right? So let's just say you have, you know, $5 million of accounts receivable at

$3 million is from one particular customer, and this is an actual example that we

had

a few years ago, and right before closing, he collected that $3 million.

And so the estimated working capital was deficient at closing,

and so he had to contribute cash to the equation.

You know, this all just goes into the calculation of what we I've talked through in

other videos or other podcasts sessions about the working capital peg.

And so the other side is, obviously, if there's a stock purchase, the bank account

goes to the buyer. Whether there's $1 in it or whether there's millions of dollars

in it, it goes to the buyer because it belongs to the corporation. And so if you

are buying stock, if you're selling stock, sometimes there's a way to get that cash

out of there. But a lot of times it's just additional proceeds for excess working

capital at closing. If you're buying assets, the bank account is not yours typically

because it doesn't it's a cashless purchase and and and so you know obviously

there's no I mean the cutoffs are really easy the bank account remains the buyer or

the sellers but even in a stock deal we we recently did a stock deal and and and

the buyer just open open up a new bank account in the name of the company, just

to keep the funds separate because it needs to be a clean cutoff,

so to speak. Yeah, that's great. Okay, so what about timing?

Help me to wrap my head around. Is this something, do I get paid for any excess

working capital right at closing? Is that going to happen later? Does the buyer have

to get their eyes on it first? How does that all work? Yeah, this is how we make

it fair, right? So, there's an estimate at closing and sometimes it's a little bit

paid on how the estimate at closing exceeds the working capital peg or the amount

that we agreed on in the agreement. Sometimes, as we just talked about,

they have to, the seller has to leave cash in the bank because of, because it's

insufficient. But generally, what happens is the buyer goes in then and has 60 to

90 days to, to figure out what it actually was. And then you kind of settle up.

And, you know, some people call it a true up where people get paid.

So then there's a 30 -day review that both parties get to do if they don't agree,

then it goes to a CPA firm to make sure that they know what is... There's always

a technique that lawyers will put in there to make it to where you can agree to

But, you know, there are exceptions. We just talked about construction accounting. A

lot of times contracts have retainage, which you're never, you're not going to get

that retainage maybe for another six months to a year. And so that part of it

sometimes is only paid when you actually receive that retainage.

And so the buyer is not out of pocket out of pocket for six months to a year to

collect that accounts receivable. Typically, the accounts receivable that is normally

in that working capital calculation is 90 days or less old.

Well, Grant, you've answered a lot of my questions, but this is still just feeling

really over my head. I'm a business owner again. What do I do now?

What do I do if I'm just still not getting it after all these questions? Yeah,

I'll just tell you. You know, a lot of people use different people to help them

sell a business or, I guess, buy a business, and they might be really good

negotiators. They might be really good at finding a buyer, those kinds of things,

but this part of M &A really requires your advisor to understand accounting and

understand how your system can yield data that will help the buyer and seller agree

ahead of time, give the buyer a heads up on what is not currently on the interim

financial statements, and you have to manage the expectations of buyers early and

clearly and so you know that's why I think we we deal with financial statements

right from the off right you yourself you know you come to the table our clients

perspective clients even will give us financial statements and you will put them in

a format, analyze them so that we have a heads up on what's missing maybe,

and then we ask questions. And that leads to our ability to advise our clients

accordingly. - That's super helpful. Well, like Grant said, if y 'all have any

questions, we'd love to sit down with y 'all, help any way we can, especially if

you don't have a trusted advisor that's already helping this arena. But that's all

the time that we have for today. Grant, thanks for joining me.

And that wraps up another episode of Integrated Insights with ICCG. Be sure to

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