If you own a business, you probably know what working capital is. It’s the difference between current assets and current liabilities, the amount of money you need to operate the business. What you may not know is what “net working capital” is. If you are selling your business to a large corporation or a private equity group, the assets you are selling are likely to include net working capital. Even at the Letter of Intent stage, you need to know how net working capital will be calculated in the sale of your business. Otherwise, you could be in for an expensive surprise.
In the sale of larger businesses, working capital is normally included in the purchase price. It is usually called “net working capital”. The amount is arrived at by deducting current liabilities from current assets. Cash and funded indebtedness is usually left out of the calculation. Funded indebtedness is debt that the business uses to finance it over the longer term. This would normally be paid off at the closing of the sale of the business by the seller. Common items included in current assets would be inventory, accounts receivable, and prepaid expenses. Accounts payable would be included in the current liabilities.
A seller needs to be careful that if working capital is included in the sale price, the amount of it, or how it is to be calculated, is well-defined in the letter of intent that is agreed to. Merely defining it as the normal working capital needs of the business, to be calculated later, can lead to a dispute over its amount later. Usually, net working capital can be well-enough defined at the LOI stage that the parties won’t be hurt significantly if it is determined later that it should have been a slightly different number.
If the business has significant seasonality, when the sale closes may have a large bearing on the amount of net working capital needed. If the business is growing significantly, the amount needed may be much higher than the amounts of historical working capital. The parties need to plan for this in their sale agreements. It is not uncommon for a buyer to have provisions that the seller’s accounting needs to be in accordance with GAAP, “Generally Accepted Accounting Principles”. This is not a general term. It refers to specific ways that accounting is done and these may not be the way the accounting was done in the seller’s privately-owned business. The buyer and seller need to understand what impact revising the seller’s financial statements to GAAP accounting will have on the calculation of net working capital.
The purpose of this blog is not to make you an expert on net working capital, just to educate you enough so you don’t ignore it when analyzing an offer for your business. Be sure to get your accountant’s advice on how much it may be and discuss with your advisors how to control how its calculation can affect the selling price of your business.