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How does working capital impact a company's value?

John Warrillow
Profile Picture of John Warrillow

John Warrillow is the founder of The Sellability Score and author of the book "Built to Sell: Creating a Business That Can Thrive Without You". Throughout his career, John has started and exited four companies and is a sought-after speaker and angel investor.

John's new book, The Automatic Customer: Creating a Subscription Business in Any Industry, is scheduled to be released in February 2015.

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Q:Working capital is one of the most misunderstood issues in the sale of a business by both advisors and business owners. Can you give your perspective on how working capital impacts a company's value?
A:

The first thing to know is that the working capital calculation is the second most important number on our offer sheet. So when a business owner gets an offer, their eye automatically goes to the most important number, which is the price that the acquirer is willing to pay.

However, the second most important number is the working capital calculation, which should be detailed in the letter of intent. It basically describes how much money needs to be in the business when the owner hands over the keys to the acquirer. There are many different ways to calculate the working capital calculation. Often times, it is the percentage of receivables. Again, it's important to get that nailed up front because business owners think the working capital is their money, whereas an acquirer will assume that the working capital stays in the company. It can have a profound impact on the total amount of money that the business owner takes from the sale. So it's really important that the working capital calculation is part of the negotiation that the owner has with the buyer prior to signing a letter of intent.

To make a business more valuable you really want to minimize the amount of working capital that is required to run the business. Working capital is defined as the amount of money the business needs to have in its bank accounts, if you will, to meet its immediate obligations. For an acquirer, he or she has to write two checks when buying a business. The first check is to the business owner for the purchase of the company. But, there also has to be a second check to the business itself to fund its working capital.

The bigger the check the acquirer has to write for the working capital, because the company buys a lot of expensive machinery or it has a terrible accounts receivable policy, the smaller the check is going to be for the owner. The opposite is also true when buyers are going to be much more inclined to write a big check to the owner if the business doesn't need any working capital to operate if the business generates cash as it goes.

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