Working capital: what stays in the business at closing

The price you agree on buys the company. But what's actually in the company on the day you take over? The cash in the bank, the money customers owe, the inventory on the shelves and the bills waiting to be paid all change from day to day. If nobody agrees on them in advance, you can pay full price for a company whose tank is nearly empty.

Here are the pieces, how buyers and sellers commonly handle them, and why a working capital target belongs in your deal.

What working capital means

Working capital is the money tied up in running the business day to day. In a small company, it's mostly:

• What the company is owed and holds: money customers owe (receivables), inventory and supplies, and costs paid in advance, like an insurance premium.
• Minus what it owes in the short term: unpaid supplier bills (payables), wages earned but not yet paid, and money customers paid for work not yet done.

You'll find all of these on the balance sheet. If you'd like a refresher, see reading a balance sheet.

A company needs a normal level of working capital to function. A plumber buys parts and pays technicians before the customer pays the invoice. That gap has to be funded by someone, every week.

The usual starting point

Many purchases of established small companies are agreed on a "cash-free, debt-free" basis. In plain terms, the seller keeps the cash in the bank and pays off the company's loans at closing, and the buyer gets the business with a normal level of working capital. It's a starting point, not a rule. Everything below can be negotiated, and it should be written down.

Each piece, one at a time

Cash. In a cash-free deal, the seller keeps it. That means you need your own cash on day one for payroll, fuel and supplies. In an asset purchase, you'll often open new bank accounts for your company.

Receivables. Whether they come with the business matters a great deal. If the seller keeps them, you won't see your first customer payments for weeks. If they come with you, look at the aging report, which sorts what's owed by how late it is. Money that's months overdue may never come in, so agree to leave it out or value it lower.

Inventory. Agree on how it will be counted and valued, usually at what the company paid for it. Leave out damaged, outdated or unsellable stock. Ask to be there for the count, or send someone you trust.

Payables and wages. Bills for parts already received and wages already earned belong to the period before closing. Decide who pays them, so they don't land on you by surprise.

Money collected for work not yet done. This one is easy to miss. A pool builder or roofer may take deposits before starting a job. A pest control company may sell yearly plans paid up front. A salon or restaurant may have sold gift cards. After closing, you'll do the work, but the seller already has the money. Those amounts should be credited to you at closing.

The working capital target

The fix for all of this is a working capital target, sometimes called a peg. Buyer and seller agree on the normal level of working capital the business needs, often based on an average of recent months. The price assumes the company will have that much at closing.

Then:

• At closing, the two sides estimate the actual working capital.
• After a set period, such as 60 or 90 days, they calculate the real figure from the final books. This is called a true-up.
• If the company had less than the target, the price goes down by the difference. If it had more, the buyer pays the seller the difference.

A target protects both sides. It keeps a seller from collecting every receivable and holding every bill in the last weeks before closing. It also keeps the buyer from getting a windfall if the company happens to be flush on closing day.

A worked example

Say you agree to buy a hypothetical plumbing company for $900,000. Its owner earnings (profit plus what the owner pays themselves, before loan payments and taxes) are $300,000, so the price is about 3 times a year's owner earnings. Monthly balance sheets show working capital averaging about $110,000 over the past 12 months, so you agree on a target of $110,000.

On closing day, the company looks like this:

Item	Amount
Receivables (after leaving out old, doubtful accounts)	$95,000
Inventory of parts	$30,000
Supplier bills owed	minus $22,000
Wages earned but not yet paid	minus $12,000
Customer deposits for jobs not yet done	minus $6,000
Working capital at closing	$85,000

That's $25,000 below the target, so the price drops to $875,000. Without a target, you'd have paid the full $900,000 and then put in $25,000 of your own money to bring the company back to normal.

Notice how much the details matter. If the old receivables had been counted at face value, or if nobody had remembered the customer deposits, the shortfall would have looked smaller.

Seasonal businesses need extra care

Working capital swings in seasonal companies. A pool or landscaping company may carry more receivables in its busiest months. A business in Southwest Florida may build up inventory before the winter season. If the target were set from a single month, whoever chose the month would win.

That's why it makes sense to base the target on an average over a full year. Look at each month's figure too, so you understand the swings you'll need to fund after closing.

What to settle in writing

Put the basics in your offer, and the details in the purchase agreement your attorney drafts:

• What's included and excluded: cash, receivables, inventory, deposits, prepaid plans.
• How the target is calculated: which months, which accounts and which method.
• Who counts inventory, and when.
• When the true-up happens, and how a shortfall or excess is paid.
• How disagreements are settled, for example by an independent accountant both sides accept.
• Whether part of the price is held back until the true-up is done.

Working capital is part of the terms of a deal, not a side issue. Our post on price versus terms explains how terms like these change what a deal is worth to each side.

Working capital and your financing

Even with a target, you'll need cash to get through the first weeks. The SBA's 7(a) loan program lists both working capital and changes of ownership among the uses of its loans, and one loan can cover more than one purpose. Ask your lender whether working capital, or a line of credit alongside the purchase loan, makes sense for your deal.

What to do this week

• Ask the seller for monthly balance sheets for the past 12 to 24 months.
• Calculate working capital for each month and find the average, the high and the low.
• Read the receivables aging report and mark anything more than a few months overdue.
• List every customer deposit, prepaid plan and gift card the company carries.
• Ask your accountant to help you propose a target, and your attorney to write the true-up into the agreement.