What’s Enough Working Capital?
One negotiation that can get, shall I say, animated as we complete diligence on a deal and finish drafting the purchase agreement is the question of how much working capital needs to be left on a company’s balance sheet at close. The reason that’s so is because the answer to the question “What’s an appropriate amount of working capital for a particular business to have?” is a kind of tautology. The appropriate amount of working capital for a business to have is whatever amount of working capital it is appropriate for that business to have.
In other words, it depends and what it depends on is a wide variety of factors. These include, but are not limited to, what the business is trying to accomplish, whether or not it wants to grow and how much, what time of year it is, what the tenor of the working capital is (i.e., is some portion of the inventory slow-moving or receivables uncollectible), and what it is used to having. And don’t underestimate the importance of that last factor. If a business has historically operated with a lot of working capital and a cash cushion but hypothetically could not (again, most small business owners tend to be financially conservative), it won’t be able to flip a switch and operate well with an optimal level of working capital if it never has. People will behave differently with more financial pressure on them, and that pressure will manifest itself in the numbers.
Further, methodology matters. It’s easy for two parties to agree that they’ll calculate an average over an agreed upon lookback period, but the devil is in the details. If it’s an average, is it a mean or median? What if there is a large standard deviation? Would you handle it differently if it’s a seasonal business and it’s high season or not? Finally, what’s an appropriate lookback period and if it’s long, should you throw out outliers?
Finally, perspective matters (shoutout Miles’ Law). Assuming all parties are being intellectually honest, a buyer of a business wants enough to slightly-more-than-enough working capital to ensure that the business can operate in normal course post-close and won’t require an additional capital injection, whereas a seller wants no more than enough to ensure that they are transitioning a good asset, but also not leaving several hundred thousand dollars (or more) on the table.
Given these slightly-at-odds aims (which can be more than slightly-at-odds if people aren’t being intellectually honest) and all of the ambiguity around the question and calculation, that’s why these negotiations can get animated. So how do we handle that?
First, we show our work. We’ll never put out a number without also showing how it was derived and why. And if you disagree, we ask that you disagree not with our number, but show us where you disagree with our methodology.
Second, we typically won’t specify a number, but a range. We’re not here to nickel-and-dime anyone and hope our partners aren’t either. As long as we land somewhere that’s approximately fair, that’s good enough.
Third, we’re always happy to agree to an after-the-fact true-up to make sure that the amount of working capital a business had at close turned out to be appropriate. Because you only had enough working capital if you ended up having enough working capital.
-Tim