Working Capital for Dummies (aka Buyers in a Seller's market)

Over the last year I’ve learned so much about ETA from many folks - Searchfunder posts, books, podcasts, webinars, and friends’ experience. The prevailing advice to searchers around working capital seems to be that you should negotiate to have the working capital needed to run the business included in the purchase price.

I'm closing tomorrow and this advice didn't work for me for several reasons. I’ll lay out the reasons below, but the key takeaway is this: in thinking about what it will cost you to acquire a business, you should assume you will need to supply the working capital yourself, on top of the purchase price. The rule of thumb I learned from several experienced folks (bankers, accountants, etc.) to estimate that amount is this: Take the annual operating expenses, divide by 12 to get a monthly average, and then assume you will need at least 1 to 6 months’ worth, in cash, in your bank account. It’s a lot of money and can easily double the “price” of a business (to the buyer.)

Why does the common wisdom to negotiate to have the working capital included in the purchase price fail? Several reasons:

#1 It’s a seller’s market. Most sellers will have more than one offer on their business. If a seller is comparing offers that don’t mention the buyer keeping the AR, or asking for some WC to be left with the business with yours, which does say those types of things, you will probably lose the bid.

I made one offer where the broker was kind enough to circle back with me and tell me that my request for the AR as a way to leave WC with the business was atypical, and was not a requirement in the other offers the seller was comparing against mine. At the time I thought I should stick to my guns, but with later offers I realized I was the outlier and wouldn’t be able to win without changing my tactic. Most of the time the seller won’t even bother to come back to you to discuss this - you get one shot.

#2 No one knows how to actually calculate it because there is no ONE way. I heard the warnings here - “sellers and their brokers won’t know how to think about this, you will have to educate them.” The accounting definition is often shared as part of this needed education: “net working capital = current assets (excluding cash) - current liabilities”, where current assets are commonly things like inventory and accounts receivable, and current liabilities are commonly things like accounts payable.

Many pros suggest laying out a methodology that involves establishing a peg during due diligence, then doing a true-up post close.

Again, the challenge here is in the practical reality that this is a complex process, sellers don’t want to do it, and if they have an offer that doesn’t include it, why would they? I tried proposing it in a few LOIs and even when you have a chance to talk through the rationale, it is a hard sell. It probably is more well received with bigger deals, but in the market I’m in, deals less than $3M, it didn’t fly.

Plus, what do you do with a business that has no inventory, and very low AR and AP? Does this mean you don’t need very much working capital? Well, no. Here is where it’s probably better to think about liquidity than the accounting definitions.

Case in point: The business I am buying is a service business (no inventory), with weekly payroll and weekly client billing. There is basically no significant AR or AP. The formula above doesn’t help you understand that the business often has over $125k per month in operating expenses. It helps that the cash conversion cycle in this business is short, but you are still signing up for a lot of stress about cash flow if you don’t have enough money in the bank to pay the bills for even one month. What if something goes wrong with your invoice collection for a few weeks? What if you need to make an investment in something like a new employee or marketing or really anything at all?

Which leads me the the last reason why this whole thing is a big deal, which is...

#3 It’s a lot of money. I went to webinars with great folks like Lisa Forest of Live Oak and Chelsea Woods of Acquisition Lab, who suggested having###-###-#### days worth of operating expenses in the bank. My QofE CPA and my franchisor suggested 3-6 months worth. That’s a lot of money!

First of all, how do you know whether 1 month or 6 months worth is needed? I am no expert and I would love to hear input from someone who is, but it seems like if you have a long cash conversion cycle or significant seasonality, you might need 6 months. If you have a short cash cycle and no real seasonality, maybe 1-2 months' worth is enough. Maybe it also depends on your access to a line of credit and your personality. But for a lot of businesses we are talking about $100-300k, and for a few businesses I looked at seriously, it would have been more like $600k.

Secondly, how do you get that much if it’s not going to be practical to get it from the seller? You have two options, borrow it as part of the loan, or bring it yourself. The usual pros and cons of debt vs. equity apply, and I think the key is to realize how much this could be early on, because it might constrain the size of business you can actually buy. I didn’t try to get a loan for a sub-contractor business with a very long cash conversion cycle and thus high WC needs, so I don’t know how hard that is. But I did make an offer on one, with the peg approach outlined above in the LOI, and the seller came back and said they would only consider my offer if I dropped that working capital provision.

So, if you can get the working capital you need included with your purchase price from your seller, congratulations! Huge win.

If not, be prepared to either borrow it from your bank and make sure that is included up front when talking about loan amounts with them, because it will be nearly impossible to add later without going through the whole credit approval process again (which would mess up your timeline to close).

Or, alternatively, be prepared to bring the cash yourself - which might lower the amount of money you have available for your equity injection. I'd say if just starting out and for smaller deals, mentally set aside somewhere from $100-300K and more if you are looking at home services/trades.

Just my perspective but I hope helpful to a few buyers out there!

Thank you so much to many people who I learned from along the way! I am indebted to this whole community and especially to my QofE provider, Midwest CPA, my loan broker Ishan Jetley, my bank, Live Oak, ALL the guests on Acquiring Minds podcasts and webinars, my Mastermind group, countless people who have written great books and articles, my dear friend Molly, and the brokers and sellers who gave me real feedback. Thank you!