Why working capital negotiation is a must to ensure successful M&A transaction

1.5 min read.

In a purchase and sale transaction of a business, the parties negotiate the price for the business and several other things. One of the common items that need agreement on is the required working capital amount.

What is working capital and why you need to negotiate and agree upon a working capital amount to ensure a fair transaction?

In a nutshell, working capital is a company’s current assets minus current liability, or typically the cash balance plus accounts receivable and inventories minus payables such as outstanding invoices and payroll taxes, etc.

The purchase price is based on the fair market value of the business. By definition, fair market value assumes that the company is able maintain operations at its optimal working capital level. In other word, no cash injection is required, nor excess working capital exists (i.e. no excess cash retained in the business beyond the required day-to-day cash amount).

After buyer and seller have agreed upon a price, the parties will need to agree on what is the target working capital at the time of sale. After about 30-60 days, the parties can review the current balance sheet and calculate what the working capital actually is, compared to the target level and adjust accordingly – either up or down. Depending on the current working capital position (shortfall or surplus), a reduction in the price will be given to the buyer, or additional cash is paid to the seller based on the difference of target and actual working capital.

Doing this right, a buyer of a business will not face with a dilemma of injecting a significant amount of cash at closing to fund the business day-to-day operations such as paying for outstanding invoices. Vice versa, the seller will be able to benefit from excess cash generated by the business if it is above and beyond the optimal cash level considered in the valuation. Feel free to reach out if you have any questions.

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