By Bianca Evans
If you’ve ever rented a car, you know that you’re expected to return it to the rental company with gas in the tank – usually, with the same fuel level as when you picked it up.
That’s a good metaphor for what strategic buyers include in the terms of most deals: the seller is asked to leave behind a specific amount of working capital so the buyer–the new business owner–can be sure they have enough money to run the business for the next few weeks or months.
It’s a technical but important term that can be confusing for some sellers. Here’s what you need to know:
What is net working capital? In accounting terms, net working capital is equal to current assets minus current liabilities. Net working capital is the amount left over each month that allows the owner to operate and cover upcoming short-term obligations. It usually consists of a combination of inventory, Accounts Receivable, Accounts Payable, and occasionally operating cash in bank accounts as it relates to customer deposits.
It’s one of the key indicators of financial viability and liquidity that strategic buyers and private equity firms look for in an acquisition, but it can become a point of contention for sellers in some deals. Buyers usually look for a ratio of 1.2 to 2.0 (assets/liabilities), which indicates financial stability and the ability to cover bills, invest in growth, and handle unexpected costs.
Factors that go into the ratio include how long inventory sits before being sold, how long customers take to pay, and how long the company takes to pay suppliers.
Why buyers ask owners to agree to include net working capital in a deal. Buyers want assurance that the business will be able to meet its obligations for the first few weeks after the sale, including accounts payable (money owed to suppliers), purchasing materials, meeting payroll, and servicing short-term debt.
Having the seller provide a specific amount of working capital also lowers the amount a buyer needs to borrow. The cost of obtaining working capital is reduced, making short-term cash flow less problematic.
How to avoid disputes about calculating net working capital. Strategic buyers will include a section in the Letter of Intent (LOI) outlining their methodology for calculating a net working capital figure, which will ultimately be determined during financial due diligence. Sellers can accept an LOI and redline the calculation pending negotiations after the diligence process.
Naturally, the seller wants the working capital number as low as possible, while the buyer wants it as high as possible. Conflicts arise because the seller’s sale price can be reduced by hundreds of thousands of dollars, which may dramatically change their profit from the sale or plans for retirement. Sellers also often balk at the idea of giving up Accounts Receivable, since they performed the work the customers have yet to pay for.
If an owner thinks they can improve or tighten the normal working capital figure, the time to do it is before they put the company up for sale. An owner can shorten customer payment terms or require up-front payments, reduce sales or processing times, or shorten the inventory cycle.
A seller may also choose to invest in a net working capital analysis to anticipate a buyer’s potential negotiating points and use the analysis’s findings to minimize purchase price erosion.
Working with an experienced broker can make estimating and negotiating net working capital numbers much less stressful for a seller. If I think it will impact a deal, I’ll have the discussion up front with an owner before we put the company on the market.
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About the Author:
Bianca Evans is a Certified Business Broker and Owner of My Florida Business Broker in Jacksonville. With over 200 business transaction completions since 2006 and multiple professional designations — including Certified Business Intermediary (CBI), Certified M&A Professional (CM&AP), and Board Certified Intermediary (BCI) — she helps business owners strategically prepare for sale, navigate deal terms, and maximize value with confidence.