The Impact of Working Capital on Selling a $5M-$25M Business
There are many intricacies to be accounted for when selling a business, and working capital is one area that you should be familiar with and the importance of its impact on business operations.
Working capital is essentially the financial health of a business determined by taking the business’s current assets and subtracting its current liabilities. This describes the short-term liquidity available to cover day-to-day operations, such as paying employees, suppliers, and managing inventory.
When selling a business, working capital is how businesses prove to buyers there is operational continuity, helps bolster a business’s valuation by instilling confidence in how it is managed, and will ultimately affect the final purchase price depending on what adjustments will be made based on a pre-agreed “target”. Let’s delve further into adjustments, impacts, and tips for managing working capital pre-sale.
Understanding Working Capital in the Context of Business Sales
To better understand its role, let’s break down the components of working capital:
Current Assets:
Accounts receivable (unpaid invoices)
Inventory (products ready to be sold or raw materials in production)
Cash and cash equivalents
Current Liabilities:
Accounts payable (bills owed to suppliers)
Accrued expenses (wages, utilities, taxes, etc.)
Short-term debt or credit lines
Buyers expect to be handed a business with enough working capital that the business will transition smoothly and maintain normal operations after the sale. To ensure that this happens, the buyers and sellers agree on a “target working capital”. This benchmark is often based on what the business has produced historically.
The target working capital is typically based on the average working capital over a defined period, such as the past 12 months. Adjustments might be made for businesses with seasonal sales cycles in order to account for peak and off-peak periods or unusual or one-time events. Industry trends such as the standard working capital can also serve as a reference.
A target set too high can unnecessarily force the seller to tie up funds and a target set too low can lead to operational issues post-sale for the buyer. The right working capital helps reduce risk for buyers in the event that there are any issues that occur post-sale, ensuring they can pay their employees, supplies, and supply customers. It also helps sellers demonstrate the sustainability of the business, increasing confidence in the financial reliability of the business.
Working Capital Adjustments in the Sale Process
Working capital adjustments occur when the actual working capital at closing differs from the agreed-upon target. This is done to ensure the buyer is not overpaying for excess working capital or buying a business with insufficient working capital which could lead to the business being run ineffectively.
If the actual working capital at closing exceeds the target, the buyer compensates the seller for the surplus. For example, the target working capital was $500,000, but the actual working capital at closing is $600,000. The adjustment is that the buyer pays an additional $100,000.
If the actual working capital is below the target, the buyer deducts the shortfall from the purchase price. For example, the target working capital was $500,000, but the actual working capital at closing is $450,000. The adjustment is that the purchase price is reduced by $50,000.
If the actual working capital matches the target then no adjustment is made, and the purchase price remains the same.
If working capital adjustments do occur, here are a few key points to help you manage:
Make sure to clearly define the calculation method and specify which assets and liabilities are included.
Both buyers and sellers should conduct thorough due diligence using historical financial data in order to set a realistic and fair target.
Anticipate the impact of timing of the closing (end of month, quarter, fiscal year, billing cycles, inventory levels).
Utilize financial experts such as advisors and accountants to help analyze trends and prepare for negotiations in order to minimize disputes.
Tips for Managing Working Capital Efficiently Pre-Sale
To achieve your goal of a smooth sale process, utilize the following strategies to attain efficient management of working capital before selling your business.
Streamline Receivables and Payables
Review overdue invoices and implement stricter credit terms for customers.
Consider offering discounts for early payments to improve cash flow.
Negotiate longer payment terms with suppliers to preserve cash.
Inventory Optimization
Perform a detailed inventory review to identify slow-moving or excess stock and create a plan to liquidate it.
Maintain an optimal inventory level that aligns with your sales cycle and forecasted demand.
Utilize inventory management software to track stock levels, forecast demand, and automate reordering.
Track and Report Accurately
Audit your financial records to confirm that all current assets and liabilities are accurately reported.
Remove any non-operating assets (e.g., personal expenses, unrelated investments) from the working capital calculation to avoid disputes.
Ensure accounts receivable, payable, and inventory match the general ledger to reflect accurate balances.
Monitor Seasonal Trends
If your business experiences seasonal highs and lows, ensure the closing timing aligns with a normalized working capital period.
Clearly explain seasonal trends and how they affect working capital–buyers are more likely to agree on target levels when they understand your business cycle.
Engage Financial Advisors Early
A professional review can identify discrepancies in your working capital and help resolve potential issues before negotiations.
Advisors can help calculate a realistic target based on historical data and industry standards, ensuring fairness for both parties.
Knowing how to manage your working capital will be a great benefit to you when you are ready to sell your business. It can maximize valuation and simplify the sale process. The best way to prepare your business for sale is to seek professional advice from advisors, such as HartmannRhodes. Reach out today for guidance on working capital and negotiations.
Mark Hartmann is a three-time Inc 500|5000 CEO with a rich sales, operations, and leadership background in the insurance, financial services, and healthcare sectors. With extensive experience growing and selling his own businesses, Mark leverages his expertise to help owners grow and sell businesses valued at $1M —$25M. He’s earned a Master of Business Administration from Eastern University, a master of science degree in organizational change management from St. Elizabeth University, and a graduate certificate in executive coaching from Columbia University. Mark’s professional certifications include Certified Mergers and Acquisitions Professional (CM&AP), Certified Business Intermediary (CBI), Certified Exit Planning Advisor (CEPA), and Certified Value Builder (CVB).