I often get clients who think that, on top of the purchase price, they will also receive a great deal of extra value in a sale from various assets such as cash, accounts receivable, inventory and the fixed assets on the balance sheet.
While it is true a seller can retrieve some value from their balance sheet above and beyond the core purchase price, sellers should temper their expectations depending on whether it is a sale of assets or shares and even on the particular buyer.
The general rule of thumb in M&A transactions regarding the sale of businesses, particularly when a sale of shares takes place, is a buyer should expect to get most or all the fixed assets required to operate the business and a “normal” amount of working capital included with the purchase price. In other words, the buyer is not going to pay you extra for the fixed assets or your working capital.
Let’s stick with share deals and talk about other points on this subject. Many of you who are owners of small security businesses may have heard that when selling your company, buyers like to buy the company cash and debt free. Doing it this way just makes the deal easier and assumes that the owner will pay off any debt and move out most, if not all, of the cash before closing. This is a very common model rule used across all sorts of small businesses.
Staying with share deals, many (but not all) buyers will expect to get a reasonable amount of working capital left in the business when it is sold. This catches many sellers by surprise but when you think about it, it makes sense. Should we expect a buyer to pay a full price for an operating company and then have to write another big cheque just to finance the business for the first few months?
Working Capital (WC) is generally defined as Total Current Assets less Current Liabilities. Too often, this is not focused on enough in most businesses. If the business is being run properly, WC should be a positive number. In a really well run business, the ratio of Current Assets to Current Liabilities should be two to one. The amount of WC required to be left in the business is negotiable to some degree and is driven mainly by the nature of the business. An integration business doing large installations will require much more working capital to cover the ongoing investment in work-in-process. A simple alarm company not requiring much investment in inventory demands much less WC. The amount of WC can also be driven by how quickly a company collects its accounts receivables.
Arriving at a mutually agreed amount of WC target to be left in the business can be a tricky negotiation. I often tell buyers they cannot just look at what WC is left in the company on average over a number of months because small business owners don’t often move excess cash out of their company or manage their WC very well. Sometimes small businesses will purposely carry extra inventory at certain times.
WC in some businesses can vary throughout the course of the year. A company selling toys will require a lot more inventory in the last two months of the year than at any other time. Failing all else, I have sometimes seen a rule of thumb of 10 per cent of sales being the WC target.
Share deals will often include a small holdback of the purchase price to ensure that the WC target is met by the seller. This holdback should be no more than five per cent and held for only 60-90 days until the seller produces the final set of financials showing the closing WC.
There is a wrinkle to the WC rule that has established itself in the sale of alarm companies. Owners sell shares of alarm companies mostly to take advantage of their capital gains exemption. Secondly, alarm companies don’t usually require that much WC for buyers. As a result, you can often see share deals done here where the seller does not have to leave WC but can actually sell off some of their assets to the buyer.
As for what happens with fixed assets in share deals, if the seller is a fire, guard or integration company and if the buyer is an experienced buyer, generally the buyer will expect to get almost all the fixed assets involved in running the business included free with the purchase price. The seller can remove any personal or unused assets such as their own vehicle or computer from the company before selling. With security companies, the fixed assets are mostly vehicles; real estate is usually held in another company.
The procedures in regards to how balance sheet assets are dealt with is simpler. With asset deals, the buyer will simply specify what assets they are buying. Having this choice is one reason why buyers like assets deals more than share deals. Asset deals in the security industry involve the seller selling the customer base (goodwill including the company name and telephone number where most of the value is contained) plus the small amount of inventory on hand and a vehicle or two. The seller is mostly left with dealing with any cash on hand, collecting their own accounts receivable and paying off any liabilities.
The purpose of this article has been to try to enlighten sellers as to what to expect in terms of getting value from their balance sheet when they sell their business. In simple terms, sellers should not expect to hit a home run from extra value on the balance sheet.
Victor Harding is the principal of Harding Security Services (email@example.com).
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