Fair warning if you are selling your business: The price you and the buyer agree to may not be the price you actually get due to a common and very important term known as the “working capital requirement.” If you’ve never sold a business before, the working capital requirement may come as a big surprise. You are likely to encounter it for the first time in the letter of intent, the first occasion when major terms of the deal are put down in writing.
Here’s how the working capital requirement can legally alter the price you receive, regardless of the number you and the seller agreed to.
In general, “working capital” refers to the specific amount by which the business’s current assets exceed its current liabilities. The availability of adequate working capital assures the buyer that they will have the funds they need to operate the business. It determines the amount of assets that you must leave in the business at closing. If there isn’t adequate working capital, the final sales price may be adjusted downward to make up the deficit. Your attorney can help you understand and anticipate the possible outcomes that can affect the actual number of dollars that come your way at closing.
Important working capital requirement terms to know
“Debt-free, cash-free” means that the buyer expects to buy the business with no outstanding loans or liens and that the seller will keep all of the cash in the business. You need to thoroughly understand the details of these terms before you sign a definitive, binding agreement. A deficit typically will reduce the purchase price if funds are needed to satisfy working capital requirements.
Working capital “based on historical levels” means that you and the buyer will look at the recent financial statements to see how much working capital has been kept on hand. This sounds simple and reasonable, but it presents a potential pitfall if you keep more capital in your business than is truly necessary.
If a buyer offers to buy a business with a “zero balance sheet,” this means that the business is to be purchased with zero dollars in working capital. This does not necessarily mean that the seller gets to keep all of the cash in the business. If cash is needed to bring the balance sheet up to zero, then cash will remain in the business at closing – or the purchase price will be reduced to make up the deficit.
The odds that a business will have a balance sheet showing exactly zero – or any other specific amount – are practically nil. For that reason, the agreement for a transaction with working capital requirements will often include two events for measuring working capital. First, an estimated working capital amount may be agreed on just before closing. Then, after closing (often within 60 to 120 days after closing), the buyer and seller will look again at the actual financial results of the business as of the closing date and determine how much actual working capital was transferred.
In each case, if working capital in the business at closing is different from the agreed amount, excess working capital should increase the payment to the seller, and a deficit should result in a reduction to the purchase price or a partial payback from the buyer.
Of course, these adjustments that change the deal price can be made only if the parties have agreed on the amount of closing working capital. If you have a letter of intent or draft agreement that does not carefully address this issue, you may still be negotiating (or litigating) this term later.
McMillan Metro Faerber, P.C.’s corporate attorneys can assist with navigating every phase of buying or selling a business. Contact us with any questions about business acquisitions and other business transactions.
