Working capital often receives less attention until the purchase agreement is being negotiated, despite having a direct impact on proceeds.
A buyer may agree to pay £10m for your business and still write a materially smaller cheque at completion. One of the most common reasons is the working capital adjustment.
For many founders, most of the negotiation focuses on valuation and the EBITDA multiple. Working capital often receives less attention until the purchase agreement is being negotiated, despite having a direct impact on proceeds.
How the adjustment works
Most acquisitions are negotiated on a cash-free, debt-free basis with a normal level of working capital left in the business. This is to avoid the seller stripping the business of its cash and receivables right before the sale and to ensure the buyer receives a business which can already finance its day-to-day operations.
A working capital target (the “peg”) is agreed before completion. Actual working capital at completion is then compared against it.
For example:
Enterprise value: £10.0m
Target working capital: £600k
Actual working capital at completion: £250k
Working capital shortfall: £350k
The £350k shortfall would normally reduce the purchase price by £350k.
If actual working capital were £750k instead, the seller would generally receive an additional £150k.
The headline valuation has not changed, and the adjustment simply reflects whether the buyer received the agreed level of operating capital with the business.
Include the working capital peg in your negotiations.
Buyers will normally look at historical monthly working capital to determine what level the company requires under normal trading conditions.
However, simply taking a 12-month average can produce the wrong result. Historical working capital may include overdue receivables, unusual supplier balances, deferred billing or other items which do not reflect the normal requirements of the business.
The seller should therefore calculate its own normalised working capital before the target is negotiated. This becomes particularly important where performance has improved: if receivables historically took 75 days to collect but management has reduced this to 45 days, a historical average may materially overstate the amount of working capital the business actually requires.
However, growth can create the opposite issue: a company that has grown from £8m to £12m of revenue may genuinely require more working capital than its historical average suggests.
It is important that sellers build a strong estimate in order to build out their leverage on this point ahead of negotiations.
What counts as working capital
Founders should also pay attention to what is included in the definition of working capital within the SPA.
Working capital will normally include operating balances such as receivables, inventory, WIP and prepayments, less payables, accruals and certain deferred income balances.
Cash and debt are usually dealt with separately, and having more cash at completion doesn’t necessarily increase proceeds (e.g. if payables or deferred income increases).
Disagreements tend to arise around less straightforward balances. For example, a seller may consider £300k of WIP to be a genuine asset, while the buyer may argue that part of it relates to poorly performing projects which will never be billed. Similarly, £500k of receivables does not necessarily contribute £500k to working capital if £100k is significantly overdue.
These definitions should be agreed clearly before completion rather than being left for the completion accounts process.
How founders lose money
One of the biggest mistakes is assuming that having more cash in the bank at completion automatically increases proceeds.
Suppose a business normally has £400k of supplier payables. Shortly before completion, payments are delayed and payables increase to £650k.
The company now has £250k more cash, but working capital has fallen by £250k. Under a conventional adjustment, the buyer may simply deduct the same £250k from the purchase price.
Delayed billing can have a similar effect. If completed work has not been invoiced or accrued correctly before completion, the seller can effectively leave value behind.
The same applies to missing supplier accruals, old receivables, customer credits and other balance-sheet items which only get cleaned up during due diligence or the preparation of completion accounts.
This is why the seller should prepare its own working capital analysis before the purchase agreement is negotiated, not after.
To conclude…
The working capital adjustment can materially change what a founder receives without changing the headline valuation of the business.
The key areas are the target working capital, the balances included in the calculation and the accounting treatment applied at completion. Sellers should therefore prepare their own working capital analysis before the purchase agreement is negotiated.