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“Working Capital” is an important part of business buy/sell transactions, but it is not a term commonly used or known by most business owners. Working capital is the invisible asset in every business. Basically, it is the ready cash on hand needed for day to day operations. Read further to understand how it is calculated for a buy/sell transaction, and how it impacts the value of the deal.

Working Capital is a measure of the funds a business has available to run its day-to-day operations. A company with adequate Working Capital can pay its bills, meet payroll, and continue operating without disruption. In the context of a business buy/sell transaction, working capital represents a necessary business asset that the buyer expects to receive along with all of the other business assets that are needed for smooth business operations, such as the tools, vehicles, and equipment.

Working capital is generally calculated by first establishing your current (short term) assets including cash, accounts receivable, inventory, and prepaid expenses, and then subtracting the company’s current (short term) liabilities including accounts payable, accrued expenses, and any excess cash that is not strictly necessary to run day to day operations.  Long term assets and liabilities held by the business are excluded from the calculation. The resulting number reflects the funds necessary and available to support day-to-day business operations. Having adequate working capital assures that your company can easily cover weekly payroll and can pay its bills on time without having to borrow money.  While business owners establish an adequate working capital figure through their experience of running the business day after day, business buyers look at the business history of bank account balances, payroll/expense payments, short term borrowing (if any), and owner draws and contributions to establish the level of working capital that should be included with the purchase of the Company. Working capital is a critical element of stock/equity transactions where the entire business, not just the business assets, are being transferred from seller to buyer. Sometimes working capital becomes a significant point of negotiation between the parties. When that happens, it is best to enlist the help of a certified public accountant (CPA) who is familiar with business buy/sell transactions.

The parties in a buy/sell transaction establish a “working capital target,” which is usually based on an average of the company’s historical working capital over a specified period (commonly the prior 12 months). This target is intended to represent a normalized level of cash necessary to operate the business. On the day of closing, if the working capital that the company has on hand is too low or too high, a corresponding adjustment is made to the purchase price. But, this reconciliation of the working capital amount typically occurs over a period of months following the closing date, with the parties exchanging their respective calculations and reaching mutual agreement on adjustments. Sometimes, a working capital escrow is established from the sale proceeds to assure there are funds for adjustments that may need to be made. Disputes over working capital adjustments occur when the process or definitions are unclear or when accounting practices differ between the parties. For this reason, precise drafting in the purchase agreement is critical. Clearly defining each component, agreeing on consistent accounting methodologies, and establishing a dispute resolution process can help avoid costly post-closing conflicts.

For business owners considering a sale, understanding and establishing working capital early in the process can help set realistic expectations and prevent surprises at closing. For buyers, careful diligence ensures that the business will have the liquidity needed to operate successfully from day one. As with many aspects of business buy/sell transactions, the details matter. Experienced legal and financial advisors can play a key role in structuring working capital provisions that are fair, transparent, and aligned with the parties’ intentions. For questions about working capital, about succession/exit planning, or about your buy/sell transaction, you can contact RC Kelly Law by phone at 215-896-3846 or by email at help@rckelly.com. 
 

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