How do you determine the right amount of working capital that should be left in the business?

By Kenneth H. Marks | Last updated: September 15, 2023

First, we start by trying to understand how the buyer thinks about working capital. We do a lot of transactions where it’s a strategic buyer and they have their own internal understanding of what working capital is. So we start by trying to understand how they do it.

We also look at normalized level of working capital within our client, the seller. We try to address the issues that we would be arguing for in the working capital negotiation before we go to market. So for example, my client is selling a company and says, "I’ve left excess cash in the business because that’s just the way I like to run it as I’m a conservative kind. But a buyer could run this business with less working capital". The thing to do is to actually take that working capital out and have it perform for a quarter or two prior to selling the company. This way you don't have to estimate whether or you’re not having to make the argument, because you’ve actually proved it. That’s one of the things if you think about preparation that you can do. You want to tighten that working capital while you own the business rather than argue that it can be tightened.

Another thing to do is to look at how other specific industry transactions have negotiated working capital. We find that different industries include or exclude different items within working capital. I’ll give you two examples: In a clinical research organization, the negotiation is around how much of the prepaid cash stays in as working capital versus comes out. Another example would be any kind of software business. Is deferred revenue included in the working capital calculation or not? In many cases, we find that it is not included in working capital. You want to know the norms within a particular industry type deal with regards to working capital.

Having a historical analysis of working capital prepared and applying an appropriate approach as the seller is also important. This will allow the seller to present the calculation to the buyer in advance. The buyer is never going to calculate working capital favorably to the seller, at least in my experience. If you have a business that’s seasonal, you’re going to want to look at multiple years and show the average working capital that is adjusted for that seasonality. An issue that sellers can encounter if you’re selling it one point in the seasonality or another, you’re either going to get taken advantage of or you’re going to leave a lot of working capital on the table.

Expanding on the point of seasonality further; buyers are typically looking for working capital level to cover a full cycle. I think is disingenuous is to try to sell a business and leave the business in a position with where you know that the cash is going to go negative or that there’s an influx of capital required. You’ve got to either adjust that in the purchase price or reflect that in the way you pitch the business as far as expectation. When an investment banker is running the process, they are expecting competitive bids, so they lay that out as an expectation in the way the present the companies. The prospective buyer will then know when they bid, that they’ve got to put X amount in to the business post closing or allocate X amount of additional capital.


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Written by Kenneth H. Marks

Kenneth H. Marks
Mr. Marks is the founder and Managing Partner of High Rock Partners, Inc. He is the lead author of Middle Market M&A: Handbook of Investment Banking Business Consulting and Handbook of Financing Growth: Strategies, Capital Structure and M&A Transactions, 2nd Edition both published by John Wiley Sons, and he authored the publication Strategic Planning for Emerging Growth Companies: A Guide for Management.

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