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Articles make things more difficult than they actually are. Even A1’s explanation is a bit academic. Working capital is just pocket money. You don’t have to worry about using it for a bill. It’s liquid, in your pocket, today, free to spend on whatever you want.
The reason publicly traded companies late pay vendors? Working capital manipulation. It’s an easy way to increase stock price.
Pro tip: don’t rely on articles to learn stuff. Way too pedantic. Easiest way to learn is to talk to people.
If you’re buying a pizzeria, and the owner has never taken his cut of the profits, so the pizzeria has a million dollars of cash sitting in a cabinet, you don’t want to add a million dollars to the purchase price to basically buy cash, so you’ll require the owner to do a “cash sweep” to remove all that extra cash. BUT, you don’t want the pizzeria to have to close through the ownership transition, you want it to have enough cash on hand to run on the day you buy it and for a bit afterwards. There needs to be cash in the register to buy pizza ingredients, pay utility bills and give customers change. So, the pizzeria owner will guesstimate that requires about $1k over 30 days. That’s the target or estimated working capital. So, $1k of cash with the business. Then, 30 days later, you sit down and look at the books and figure out how much cash was actually used to buy ingredients, give change, etc which is your “actual” working capital. If it was less than $1k, you give the excess back to the seller because you didn’t actually need that much on hand for the business transition. If you spent more than that estimated $1k, depending on how your agreement is structured you might get a credit against an escrowed portion of the purchase price or some other adjustment.
A2 most cash free debt free purchases still have working capital adjustments…
Let the almighty Investopedia guide you my friend.
Current assets minus current liabilities?
To add up on the last comment, working capital is a very important indicator as it shows whether a business is able to auto finance its operations or if it constantly requires outside capital (especially for growing businesses). See it this way, if you have to pay your bills right when they get to you but you receive the money from your sales in a longer period you’ll have to borrow external capital in order to pay for the immediate bills. In an opposite way, if you receive the money before you have to pay your suppliers, you’ll always have excess cash to reinvest and compound in value 👍🏽
Every time I see it in asset deals I’m like why can’t they just agree on price on it is so moronic
Okay- the deals I worked on it was always simple- inventory price adjustment only.. not that I’m working on bigger deals I’m seeing the working capital stuff but even then it gets taken out with some regularity to make things easier
Alright, now someone tell me if cash on hand is the same as closing cash. And why is the definition of cash heavily negotiated in purchase agreements?? This thread has been very helpful.
Naw they're different. Cash on hand is actual cash in the bank account. "Cash" or "Estimated Cash" is negotiated heavily because that cash ain't always your cash and in a "cash free" deal you're not going to be passing cash over to the buyer as a part of working capital.
Some of it may be what's called "restricted cash" which is cash your business needs to set aside because you haven't earned it (like an unearned retainer). Many times this is treated like debt and you walk with the actual cash but your buyer nets that debt amount against the purchase price.
Some of it may be cash set aside for uncleared checks. Theoretically your buyer could do something similar to restricted cash and let you walk with that amount, but then those checks might bounce. So many times you agree to leave some cash in the business and the Buyer brings some extra cash to closing.
There are other potential issues that can arise (customer deposits, security deposits, tax assets received after closing, etc), but the moral of the story is, all that cash sitting in seller's bank account might not actually be the seller's, it could properly be a part of the working capital Buyer needs to get achieve the cash flow it's buying through this business, but in a cash free transaction it won't figure into the working capital mechanics.
Edit: and L1 is right, this isn't "negotiated heavily" so much as Buyers and Sellers do need to put some thought into how to deal with removing cash out of a going concern.
SRS Acquiom has a one pager on their website worth looking at
I also
I assume you are talking about the typical “net working capital” adjustment in an M&A context. If so, the other replies so far are not very helpful.
In this context net working capital typically means a business’s non-cash current assets (like inventory, accounts receivable, and other assets that can be readily used or converted to cash within 12 months) minus its current liabilities (like accounts payable, accrued but unpaid rent or royalties, accrued but unpaid employee compensation, short-term revolving facilities, etc.).
Most M&A deals are priced based on “enterprise value” which is the value the business would have it were free of cash and debt. Sellers are typically entitled to sweep out cash (or get paid extra for it) and are typically required to satisfy all debt (or have it deducted from the purchase price).
If you put on your “unscrupulous seller” hat, you’ll see an opportunity for manipulation here. A seller could accelerate receivables (invoice faster and pull in favors to get customers to pay early, perhaps even at a discount), drawdown inventory, put off settling accounts payable, etc. to create more cash (or reduce debt). This would put more money in the seller’s pocket but put the business in a hole that the buyer would need to invest a lot of capital to recover from. You could put in a covenant (and actually typically do put in a covenant) that the seller won’t do this, but it is hard to police that and the remedies for a covenant breach aren’t super-attractive.
So almost every business acquisition is valued not just cash-free, debt-free, but assuming *a normal level of working capital.* The parties agree on a working capital “target” or “peg” which is supposed to reflect what “normal” working capital the buyer can expect. If the business is delivered with that normal level, then all is good and there’s no adjustment. But if the working capital falls short of normal, the buyer will reduce the purchase price by a corresponding amount. If working capital is higher than normal (perhaps because the business as overperformed or because the seller has been too distracted closing the deal to collect receivables as promptly as normal), that excess pre-closing value gets paid to seller. So it takes out any incentive to manipulate working capital and helps ensure pre-closing operations accrue to seller.
This is a directly economic point and there’s a lot of opportunity for manipulation, so parties should (and generally do) focus intensely on making sure they understand how working capital should be calculated for this purpose, what the right “normalized” level should be (which could perhaps be a range rather than an exact dollar value), and how any disputes around the calculation would be resolved.
Thanks for this explanation. I was involved in selling businesses that had virtually no A/R and no A/P so it was rarely an issue