Originally published online at Crain’s Cleveland Business
Planning for the sale of a business must extend beyond the close of the actual transaction.
To operate a business in its traditional manner, whether the transaction is an equity or asset sale, all buyers expect that the business will be left with sufficient working capital to operate on a day-to-day basis. The parties must recognize that a business is a living organism. Every day, products ship, receivables are collected, and invoices are paid. The sale price should not be affected by the happenstance of a day’s activities. The absolute value of the business doesn’t change; therefore, neither should the purchase price.
In planning for the sale, the parties should agree on the working capital to be left in the business (“peg”). Cash is retained by the seller. Working capital consists of inventories, receivables and other current assets, less accounts payable, accrued payroll, customer deposits and other current liabilities. In some instances, receivables, payroll and trade payables may be retained by the seller. The difference between a buyer’s determination of working capital at closing and the amount perceived by a seller can be tens or hundreds of thousands of dollars.
The parties often average the ending working capital amount over a six-to-12-month period. The seasonality of a business may need to be factored in. Further, in a fast-growing business, a working capital target based on anticipated growth may be more appropriate than one based on historic performance.
In setting both the “peg” and the closing date working capital amount, it is critical that the parties utilize the same measurements. Measurements utilized by the seller in its operation of the business are often not used by the buyer in determining the closing date amount. To illustrate, a buyer will insist on utilizing GAAP accounting practices. These rules would impose bad-debt reserves and/or inventory reserves for slow-moving or obsolete items that were not factored in setting the target number. Many private, small businesses do not utilize such reserves. The inclusion of these reserves would then artificially reduce the purchase price amount where there has been no true change in the business. Other adjustments may be proposed by a buyer that depart from the practices used by a seller.
I have found it extremely useful to include as an exhibit to the purchase agreement an example of working capital and a statement that the closing date working capital must be determined by utilizing the exact same accounting principles as were used in determining the example’s working capital. The example includes all categories of current assets and current liabilities used in the calculation, even if a category’s dollar amount is zero.
Once the buyer prepares the closing date working capital statement, the seller generally is given time to review the statement. If the seller agrees with the conclusions, the closing adjustment amount is paid either by the buyer (if the peg is exceeded) or by the seller (if there is a deficiency). If the seller disputes these calculations, the dispute is often referred to a neutral accountant for resolution. Due to the nature of the conflict, a working capital dispute is best resolved by an accountant rather than by a judge or arbitrator in litigation.
Finally, sellers must be aware that, similar to a holdback or escrow utilized by buyers to protect themselves against representations and warranties breaches, buyers generally want a short-term holdback or escrow for possible working capital adjustments. Buyers generally do not want to chase sellers for monies owed. If there is already an escrow established for the buyer’s benefit, then including the working capital holdback should not be an issue. However, if there is no existing escrow, then a short-term holdback is likely more efficient.
Careful planning with skilled advisors in the purchase agreements can greatly diminish post-closing disputes.
