With any purchase in life, if there’s a large item at the bottom of the bill that you don’t see coming that makes your grand total larger than you expect, you’re generally not pleased. When you are talking about business transactions, working capital is precisely one of those “didn’t think about that” amounts that buyers don’t realize is a necessary part of running a business after a transaction is completed and should definitely be on their minds as they move towards closing on a sale.
In this particular case, the textbook definition of working capital isn’t helpful. That’s because it’s defined as your current assets minus your current liabilities. The other unhelpful definition, which is used by too many systems-less business owners, is “the business checking account balance.” The proper way to think about working capital is the amount of money you need to keep the business going: paying for your overhead and your staff and a little extra.
Working capital needs are going to vary based on the type of business. Think, for example, about the seasonal fireworks stands or Christmas tree businesses. They have a lot of their working capital essentially tied up in inventory that needs to sell over a period of a few weeks. Their working capital needs are much higher than, for example, a training business that collects all of the payment upfront and then uses those funds over a period of weeks or months to pay for the resources needed to complete that training.
When calculating your working capital needs, the four categories you need to explore are:
- Receivables (when do you get paid)
- Payables (when do you pay your vendors and staff)
- Inventory (how much do you have in stock and how quickly does it turn over)
- Time (how do the three previous categories interact)
How to Obtain It
On some larger deals working capital can be negotiated into the transactions, with the buyer taking on some of the payables in exchange for some of the receivables and cash. On many Main Street transactions, however, like the ones we handle here at Apex, we simply counsel our buyers to make sure that they have the working capital in place, whether that’s by setting aside some additional capital or by getting a line of credit or a combination of the two.
Communication with the seller is key here and when it comes to working capital, you’re never going to get penalized for having too much of it to start off…but too little, and you’ll have the worst kind of problems imaginable.
So far we have been talking about working capital as a means to sustain a business. But what about if, like most buyers, you want to grow a business? Well, you’re going to need more. Where can you obtain that working capital?
- From your retained earnings. This is the easiest place to find the funds.
- From a line of credit or crowdfunding. This needs time to get set up (having a bank relationship or preparing the proper paperwork for an offering) so you’ll want to do it before you need it.
- Alternative financing. This is typically used if you can’t find other means of financing, but it should be considered against the profits you are hoping to gain in growth, as this is the most expensive form of financing out there.
This is also another conversation that can be had with the seller. “If you had more money to grow the business, where would you deploy it?” and the natural follow-up, “How much do you think that would cost?” The seller wants you to succeed: it’s part of the motivation behind the transaction. However, to err on the side of safety, when it comes to working capital, always remember to add at least 20% onto any estimate they give. If you have some extra, again, that’s better than not having enough.
Do you have questions about whether you have the right amount of working capital in your business or are you considering buying a business and want help calculating how much working capital you’ll need? We’re here to help.