Working Capital: How Can the Seller Prepare for the Debate?

The question: how could a seller prepare for a debate on working capital?

When buying a business and conducting their due diligence investigations, a buyer and his advisors might be doing everything they can to find data which points to a high working capital requirement for the business they are purchasing.

What could a seller do to prepare for the debate?

"Do nothing" is one answer that is debated regularly in my training rooms. And I understand the point of view. The logic is that the purchaser might not raise working capital as an issue at any point. The seller bargains on purchaser ignorance or purchaser stupidity or their own absolute confidence that any detailed investigation will show that the business is being sold with a robust working capital position. Personally I think this is a risky strategy and the seller could find themselves suffering a price reduction late on in the process.

What's the alternative strategy?

The alternative for the seller is to work to prepare themselves in advance of a potential argument. The seller could present a picture of "normalised working capital" for the business and argue that any extraordinary fluctuations e.g. two years ago were one-off. This strategy sees the seller trying to get on the front foot and looking for an opportunity to present their own view of working capital.

Opportunties for the seller to present their own picture of working capital include:

1. The IM. The information memorandum, released early on to all bidders in the process, could contain a broad overview of working capital requirements. In practice I have rarely seen this done though.

2. Vendor due diligence. In something called vendor due diligence, the seller could commission accountants to provide a detailed picture of the business's finances and release this to short listed bidders. Alternatively, without commissioning a large piece of vendor due diligence, the seller could just ask his advisors or accountants to provide some supplementary information on the business's working capital position, once the identity of short listed bidders is known.

3. Dataroom. The seller could provide some information on working capital in the dataroom. this is relatively late on in the process when the buyer has his own accountants trawling through files of information on the business's contracts and finances. Success here assumes that a number of buyers are proceeding through to this phase of the process (or at least waiting in the wings, eager to jump back into the process) and the seller is not already stuck with one bidder who is looking for any excuse to chip away at the price.

Wan't it the scouts who had the motto "be prepared?". And yes, in case anyone is wondering, I was one of them and obviously something stuck!

Alternatively, if there are some fly-by-night advisors reading this, and all of 1-3 sounds like too much trouble and work, there's always the "do nothing" option. I'm happy to be argued with but I'm still thinking it's a recipe for a price reduction and a grumpy seller!

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How Might Working Capital Affect Negotiations?

Let's imagine that a buyer of a business had gone to a lot of trouble (or, at least, his due diligence advisors had gone to a lot of trouble) to determine the working capital requirement for a target business. I'm guessing, or at least experience is telling me, that the buyer and his advisors have been doing their best to find a higher than expected working capital requirement.

What would the buyer do with that information i.e. the data that shows a higher than expected working capital requirement?

The buyer could use the information to argue for a price reduction.

This is on the basis that he needs to reserve funding capacity to cope with the working capital fluctuation. Because of the working capital fluctuation, the buyer can’t afford to pay as much to the seller. For example, as debtors increase the drain on cash flow will have to be funded with extra debt secured over the business, debt capacity will have to be reserved to cope with this fluctuation, and less funds can be raised at the start of the transaction to pay the seller.

Knowing that the buyer and his advisors are going to be doing everything they can to find a high working capital requirement and argue for a price reduction (am I being a little too cynical here?) , what could the seller do? Should they just sit and wait for the inevitable price chip? What could the seller do to prepare themselves for the debate?

See the next the next "working capital" post...

FTA Ltd runs CPD courses for lawyers, bankers, finance executives, accountants and other financial-services professionals. See www.cpd-courses.org for more information.

How is working capital calculated?

The question: how is working capital calculated?

What we are trying to do here is answer the question (perhaps first pitched at the finance director) which asks: "how much short term funding would you need to run this business?" Here are some ways of finding the answer.

1. Look at the management accounts

Interim management accounts will detail operating balance sheet items that have an impact on the short term funding requirement for the business, including debtors and creditors. The excess of debtors (the people who owe the business money = a funding requirement) over creditors (the people who the business owes money to = a source of funding) represents a net funding requirement for the business.

As the business grows, debtors go up, more people owe the business money, and its short term funding requirement increases.

2. Look at the bank statements

There are other ways of estimating the working capital requirement. One of the main ones is to look at the bank statements, adding back items that are involved with the long term financing of the business, so that we are only left with entries that relate to short term operations.

Looking at the bank statements will tell you about within period fluctuations which are often greater than the between period fluctuations in the management accounts.

3. Construct a cash flow forecast

None of the above takes account of expected future growth for the business. In a growing business, forecasting forward sales, debtors and the cash flow required to fund those debtors could lead to a much higher estimate for working capital requirements. Considering the history is not enough. At Financial Training Associates we regularly run training courses for bankers who wish to construct fully integrated financial models in Excel. They don't want to take a proposal to their credit committee, lend to a business and find it unexpectedly asking for more money immediately post deal.

4. Ask the finance director.

A good finance director will be monitoring his cash flow and will know what the swing within the year is. "Ask the finance director" was suggested to me by a very experienced banker in one of my class rooms once, when we were talking about ways of determining working capital. I hadn't expected that answer. I had been expecting to hear about one of the other three methods detailed above. Foolishly perhaps, I asked a question: "What do you do if he doesn't know the answer?". Again, I expected to hear about one of the methods outlined above. "Get another finance director" was the dry response that came back! It was a very good answer and so asking the finance director is on my list permanently now!

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What is Working Capital?

The question: what is working capital?

Working capital is a concept or an idea rather than a precise mathematical construct. Essentially working capital is the answer to the question: "How much short term funding do you need to operate this business?"

There are some ways of estimating working capital (see "How is working capital calculated?") but each is an estimate of the short term funding required to operate the business.

Short term funding is important in a transaction because, with long term funding in place to buy the business, the business still needs short term funding to operate. Without the short term funding, post deal the business will go bankrupt.

About training company FTA Ltd

FTA Ltd is a company that provides finance-related CPD training courses to law, accountancy, banking and financial services professionals. See www.cpd-courses.org for more information.