When you buy a business, don’t just think about buying the goodwill and the equipment and hiring the key people, consider where your working capital is coming from. If you don’t plan on where it is coming from, you may have to provide it out of your cash after the sale closes. The typical sources of working capital are the seller, a lender, or you. Which of these sources is used depends, to some extent, on the size of the business being sold.
You probably know what working capital is, but just in case you don’t, here is an explanation. Working capital is the difference between current assets and current liabilities in a business. You can also think of it as how much money you normally need in your bank account to operate the business.
In the sale of very small privately owned businesses, where the seller is financing a significant part of the purchase price with a large buyer down payment, the buyer is probably using her cash reserves to fund the working capital of the business. In many of these businesses, the need for working capital is not large.
As we move up to the sale of larger privately-owned businesses, ones where an individual is still likely to be the buyer, the lender is likely to supply the working capital. Most of our sales of these businesses are financed with SBA loans, or other loans from banks, and including the working capital needs of the business in the loan is common. The SBA loans are 7A loans, with a maximum loan amount of $5,000,000, so the business can be a larger business for most individuals to buy. Note that working capital is included in the loan, but is not part of the purchase price.
In the sale of these businesses, buyers are buying assets and may buy the accounts
receivable. If so, collecting them may be adequate to supply most of the working capital, but it doesn’t put any money in the bank account on the day of the sale. In this sale, the accounts receivable and any additional working capital can be included in a loan from a third party lender.
In the sale of larger businesses, working capital is normally included in the purchase price. It is usually called “net working capital”. The amount is arrived at by deducting current liabilities from current assets. Funded indebtedness is usually left out of the calculation. Funded indebtedness is debt that the business uses to finance it over the longer term. This would normally be paid off at the closing of the sale of the business by the seller.
A seller needs to be careful that if working capital is included in the sale price, the amount of it, or how it is to be calculated, is well-defined in the letter of intent that is agreed to. Merely defining it as the normal working capital needs of the business, to be calculated later, can lead to a dispute over its amount later. At the offer stage, the buyer usually has seen the income statements and balance sheets for several years and should be able to estimate the working capital needed from them.
How working capital is obtained can vary significantly. As a buyer or seller of a business, you need to pay attention to how it is being handled.
