Working Capital Assessment is Complex and Impacts Deal Value

The complexity of determining future working capital requirements comes as a surprise to owners of recruitment agencies selling their business.

“But I’ve managed my cash flow for years”.  Yep.  “I know what my cash requirements are going to be for the next 3-6 months”. Yep.  But you are likely to be selling your business as a going concern, which usually means average working capital requirements have to be kept in the business when it is sold.

Getting this working capital calculation right is important for a number of reasons. Firstly you want to maximise the funds withdrawn from the business on settlement of the sale, as this can make a large difference to the total value you get to take home from the transaction.  Not knowing your working capital requirements can give you a misleading understanding of the total value of the business.

Related: Net working capital

But there is also a credibility issue here. Most small to medium recruitment businesses sell to an organisation that is larger, has more sophisticated financial processes, and greater “corporate” experience. You do not want to be on the wrong end of a last-minute high-pressure conversation on this topic, and you do not want to disappoint by creating distrust with the other party due to a lack of clarity on this important topic.

I’ve spent some time with David Payne of The Accounting Department to discuss this topic, for it is a topic for the specialists.  It is common that the working capital calculation will be managed by the vendor’s external accountants and the acquirer’s external accountants. HHMC Global and The Accounting Department would prefer the selling organisation be “aware” and have a clear understanding of working capital requirements prior to entering a sale process.

We have found that when there is upfront agreement on the principles around the calculation of the working capital adjustment, there is one less major item that can derail a sale transaction.  The principles are that the parties:

1. Understand Why

Given that selling a business can be emotional, it is important that emotion is taken out and the need for a working capital adjustment is understood.

Contracts have a working capital adjustment because account balances that make up working capital change daily and having an agreed working capital adjustment formula allows each party to have peace of mind during the period after the contract is signed and before settlement that:

• the vendor is not going to delay paying suppliers, aggressively collect receivables, thereby reducing the working capital that the purchaser has post-settlement; and
• the acquirer is not going to have a windfall gain due to matters outside of the control of the vendor, such as a customer paying after settlement, instead of before settlement.

2. Agree upon overriding working capital adjustment parameters upfront

Agree upon the following big picture overriding concepts up front:

• the accounts will be taken into account when calculating the adjustment (i.e. receivables, prepaid expenses, payables, accrued expenses, employee liabilities);
• the average account balances that will be used, taking into consideration seasonal adjustments (allowing for increased working capital requirements); end of day or end of month averages; and the period of time that the average is to be calculated over (6 months, 12 months – comes down to the particular business);
• normalisations, such as the impact on working capital of related party transactions, including the employment liabilities related to the owners; and
• putting in place thresholds on post sale adjustments to avoid having to deal with minor items.

3. Accounting Principles

As the management accounts will be relied on to calculate the working capital adjustment, the parties should define in the contract the level to which the accounts are to be prepared. This will help as:

• there is a difference between tax accounts and management accounts;
• the company may not have the internal resources or skill set to prepare management accounts to the required level, and therefore may need external assistance in the lead up to the sale process; and
• disagreement between the parties’ external accountants prior to settlement can kill a transaction.

4. Include a Proforma Working Capital Adjustment

At the time of negotiating the sale contract, include an annexure with every balance sheet account from the company’s chart of accounts, including those with a zero balance, and how, if at all, the balance of that account at settlement will impact the working capital adjustment.  It may be that the balance of the account has already been taken into account with the purchase price, (or so one party is of the opinion - it is best for both parties to be clear).

5. Get Advice from a Specialist

You have worked hard to get to the point of selling your business and a single innocent mistake at this stage can be costly. So, just like if you’ve had a heart attack your GP will refer you to a cardiologist, you should expect your usual tax accountant to refer you to a specialist who deals with sale transactions every day.

These discussions on working capital add to the emotion and complexity of a sale. During the transaction process there will also be greater emphasis on the revenue and profit forecast, and immense pressure to meet forecast each month. And on occasion, the size and type of loans in the business can impact settlement values and tax obligations.

All the more reason to ensure these aspects are dealt with early, and you have specialists on your team that can keep you in control and well informed.