News Lessons Learned Opinion
The role of working capital in acquisitions

The importance of working capital took on a new meaning for me when I started brokering share deals for fire, guard and integration companies.

Just when I thought a particular deal was all wrapped up, the buyer raised the issue of how much working capital was to be left in the company when the deal was closed. Truthfully I had not realized this was an issue and I certainly did not fathom just how complicated this issue could get.

I now understand that working capital is not just important when operating a business but also when you go to sell. And as a seller, if you are not careful, you can leave significant amounts of money “on the table” in working capital.

Most of us realize how important having adequate working capital is to operating a business successfully. Without working capital, an owner may not be able to pay their staff on time, buy the inventory necessary to run the business, pay their payables on a timely basis, and so on. Owners should take some or all of the following steps to ensure they have enough working capital:

• Make sure the business is properly capitalized in the beginning
• Go to the bank to get a line of credit
• Try to collect receivables faster

Common sense suggests that if working capital is important to owners operating their business, then it is reasonable to assume that it will be equally important to a buyer when buying that same business.

Let’s define working capital. Working Capital is the net of Total Current Assets less Total Current Liabilities where current assets are generally seen as cash, accounts receivables, inventory and prepaid expenses less short term bank debt, account payables, accrued liabilities and customer deposits or deferred revenue. Classic business theory says that a good working capital position is where the ratio of total assets to total liabilities is 2 to 1.

So we know having adequate WC is essential to running a business successfully. But what’s it got to do with the selling of a company? The reality is that the amount of working capital to be left in a business when it is sold does factor into the selling process of most, but perhaps not all, deals.

Sellers need to realize that they will most likely have to give up some or all of their receivables and inventory to cover their payables and accrued liabilities and give the buyer some extra WC to run the business. The key question revolves around just how much the seller has to give up.

Before we get into the actual amounts lets spell out where working capital typically figures in the sale of security companies. My experience is it factors more when a sale of shares takes place than a sale of assets because in a sale of shares, the buyer is taking over the complete business with staff and everything whereas in a sale of assets the buyer can pick and choose what they want to buy and seldom buy existing liabilities.

Secondly, working capital plays a bigger role in the sale of fire, guard and integration companies because, a) when you are buying one of these three types of companies, share deals are done more often and b) working capital plays a bigger role than in the sale of alarm accounts. Whether it be a share sale or asset deal, buying alarm accounts does not require the buyer needing that much extra working capital. The buyer is not usually taking on that much extra staff or added expense.

So how does working capital enter deals? The buyer’s rationale is that if they pay a sum to a seller to buy their fire or guard company, they do not want to have to write a big cheque the second day they own the business to provide working capital so the company can operate. This seems very fair to me but you would be surprised at how many owners are shocked when they are told that they have to give up a portion, sometimes a large portion, of their receivables and inventory free of charge.

How much working capital has to be left in the company and what is included in the definition of working capital? These are the two questions that buyers and sellers wrestle with in completing a deal. Having had to handle these two issues several times in completing deals I have this advice to all sellers:

• Work towards setting a working capital target in actual dollars and try to get this issue settled as early as possible in the deal process — if possible, before a Letter of Intent is agreed to.
• Deferred revenue and customer deposits are often included in the definition of WC and can be a tricky item in negotiating WC targets. Most buyers of alarm accounts will want all the deferred revenue included in the calculation which can increase the WC requirement significantly. I usually bargain for some, not all, of the deferred to be included.
• Don’t let the buyer talk you into using an average of what working capital was in the company over the last 12 months. An average amount has nothing to do with what is actually required. Most owners of small companies don’t spend that much time optimizing their working capital. They leave extra cash in the company for months on end and don’t always collect their receivables as quickly as they could. They also leave more money wrapped up in inventory than they need. Calculate what working capital is really required to run the business not what just happens to be there.
• The amount of working capital required to be left varies greatly on the type of business being sold.
• I have seen certain rules of thumb used to arrive at the amount such as 10% of sales or two months of expenses but even these are not as good as actually figuring out what really is required.
• While the seller should be wary of not leaving too much in the company when they sell, they should also not crater the deal but holding out too stridently for a certain WC number or create a lot of bad will early in the new ownership period over a few thousand dollars of working capital.

Victor Harding is the principal of Harding Security Services (victor@hardingsecurity.ca).