Large Working Capital Requirements When Selling a Business
In the last issue (#70) we discussed the obstacle produced by Real Estate Value Too High vs. Return On Investment. In this issue we’ll discuss the obstacle created by Large Working Capital Requirements.
"Many receive advice, only the wise profit from it." Publilius Syrus
Large Working Capital Requirements When Selling a Business
Owners need to be aware that large working capital requirements can be an obstacle to salability or, more likely, to maximizing the value of a business.
Why are large working capital requirements an obstacle to a possible sale of a business? One way or another, almost all business acquisitions are financed. Typically a prospective buyer will need to have a 20-30% down payment. It only makes sense that as the amount of cash required for a down payment increases, the buyer pool decreases. For instance, there are more prospective buyers for a $500,000 business where a $150,000 down payment might be required, than for a $1,500,000 business where a $500,000 down payment might be required.
In addition to the down payment, buyers also need to have sufficient working capital to survive the cash crunch created in the first 60 – 90 days when customer accounts receivable collections may take 45 – 90 days but the buyer needs to maintain strong relationships with vendors, potentially paying them in 30 days or less. That need for additional cash reduces the pool of prospective buyers. In addition, if the prospective buyer finances the working capital needs with a line of credit, the interest expense on the working capital loan needs to be imputed into the recast financial statements, thus reducing the level of Seller’s Discretionary Earnings (SDE) on which the value of the business is based.
An example of the effect of large working capital requirements
For example, a distributor of steel beams selling to general contractors in the construction industry may have a collection period of 90 days or more. If the company’s annual sales are in the area of $6,000,000, its accounts receivable might average about $1,500,000 ($500,000 per month x 3-month collection period). If required to pay its vendors in 30 days, the working capital requirements might be as high as $1,000,000. At 10% interest on a working capital loan, the interest expense would be $100,000. If the business has $400,000 of cash flow prior to working capital interest, it would only have $300,000 of cash flow after imputing working capital interest. In this example, the need to impute working capital interest of $100,000 reduces the business valuation by approximately a multiple of 3, or about $300,000.
Working capital interest should not be an add-back to SDE
Ordinarily, interest expense is added back to SDE, but working capital interest is handled differently. When the nature of the business model requires a buyer to maintain a working capital loan, working capital interest expense is unavoidable and needs to be considered in the calculation of the buyer’s future cash flows.
Drivers of working capital needs
The three primary drivers of the need for a large amount of working capital are (1) long collection periods on accounts receivable; (2) inflexible payment terms from vendors/suppliers; and (3) the need to carry large amounts of inventory.
Small business owners need to be aware that large working capital requirements can be an obstacle to salability or, more likely, to maximizing the value of a business. By working to (1) reduce accounts receivable collection periods; (2) improve vendor /supplier terms; and (3) find ways to reduce inventory requirements, you can improve the prospects of your financial freedom from the sale of the business.
How large are your working capital requirements? …..
