Reduce working capital to maximize value
By Scott Bushkie – CBI, M&A Advisor
We’re working with a few clients who have built up very successful companies. They have great reputations and solid teams, but they’re all struggling with one particular challenge: their net working capital requirements are very large compared to the earnings produced.
They’re not necessarily doing anything wrong, as some industries require more working capital than others. But the imbalance is limiting their buyer pools and the money they’ll take home.
Working capital is a measurement of operating liquidity, most of the time it is calculated as AR, inventory and prepaids minus AP and accruals. Lines of credit are most often excluded as well as cash, long term debt and notes payable. Because working capital is required to run a business, buyers typically require a certain amount of net working capital be left in the business to meet standard operating needs.
Working capital is not typically used in calculating the initial offer price, although it is certainly a critical point of negotiation. But basically, the higher your net working capital, the less money you put in your pocket after a sale.
Imagine a business that generates $100 in revenue with $20 in EBITDA. This business has $70 in AR, $30 in inventory, and $60 in AP for a net working capital of $40 (70+30-60). The business sells at a four-multiple of EBITDA or $80, but the seller needs to leave $40 of working capital in the business.
At that price, 50% of the business value would be required to be left in the business as the net working capital is needed to run the business. Sometimes, we see even greater extremes, with working capital pretty much equal to the business valuation.
It’s disappointing when sellers run their businesses for so long only to find out that their value matches their current need for working capital. At that point, you have to evaluate the best way to exit your business. You can sell off the assets or you can keep the company legacy going, make sure your employees still have jobs, and try to negotiate value in different ways.
In one recent negotiation, for example, the seller was looking at about $500,000 in take home cash on a $2.1-million-dollar valuation. However, the seller owns the business real estate debt free and can gain additional revenue by renting the facility to the buyer.
Plus, we negotiated several hundred thousand more in earn outs, predicated on performance over the next few years. What’s more, the seller wants to stay involved in the business (without the stress of ownership), and that employment contract comes with a nice compensation package. Add all that together and we’re a lot closer to achieve the seller’s ultimate goal of retirement.
But in some cases, the high ratio of working capital to cash flow just doesn’t make sense for buyers, and those companies may have trouble selling at all. We recently fielded 10 indications of interest on a business. They all came in right around the same purchase price, but when buyers dug deeper into the financials and realized the amount of financial assets they’d have to tie up, compared to the returns, some withdrew their offers.
Trimming Working Capital
The more you can reduce net working capital requirements, the more goodwill you’ll gain in value. Start by getting diligent about collecting on receivables.
If you’re averaging $1 million in receivables each month and you collect in 30 days, that’s $1 million of current assets factored into your working capital. But if you’re collecting that same $1 million in 60 days, you’ve essentially increased your current monthly assets to $2 million, so the difference between collecting in 30 days or 60 days becomes $1 million less in your pocket.
Look at your inventory and run as lean as you can without jeopardizing business. If you carry $1 million in inventory when you only need $700,000, that’s another $300,000 you’ll have to leave in the business.
Finally, on the payables side, determine whether you could make better use of other people’s money. Some successful business owners pay all their bills right away, simply because they can, but those fast payment habits create an AR/AP imbalance that drives up working capital. Do what you can to stretch out payments, as appropriate, without damaging relationships.
Begin optimizing working capital at least a year prior to sale. Buyers will usually calculate their working capital target using a 12-month average of your financials. Plan ahead and you could take home several hundred thousand dollars more when it comes time to sell.