Mike Bigrigg, CPA/ABV, shows why you may need a business valuation:
We often perform business valuations for clients involved in the potential sale or purchase of businesses. Many times, the buyer and seller disagree over how net working capital, which is typically defined as all non-cash current assets less all non-debt current liabilities for business transactions, should figure into the purchase price.
Many sellers believe they should receive the value of the company based on income or market-based valuation approaches and be able to retain any net working capital of the business, which in many cases is composed primarily of uncollected accounts receivable. This creates an issue for the buyer because the value of a company based on income or market-based valuation approaches is dependent upon the company being delivered to the buyer with a sufficient amount of net working capital to continue business as usual. Delivering a company to the buyer with no working capital because the seller has retained these assets results in the buyer needing to fund the working capital shortfall out of his own pocket, which would effectively increase the purchase price.
We recently advised a client on the purchase of a fuel distribution company. The seller retained all of the accounts receivable and all but $100,000 of inventory. We performed a business valuation, and were able to adjust the purchase price for these items to ensure our client did not overpay. In addition to our valuation analysis, we performed an extensive, weekly cash flow analysis to help our client determine additional cash that he would need to cover working capital needs in the near-term. With the seller keeping most of the inventory and all accounts receivable, our client, the buyer, needed cash to purchase inventory and cover operating costs for about one month before collections would be made on new sales. Our cash flow analysis also allowed our client to consider changes in the cost of fuel that would impact the amount of working capital needed. This analysis was extremely important to our client because it allowed him to get the proper amount of financing and estimate the amount of time that would be required before the business would begin to cash flow on its own.
In other circumstances, we have been involved in transactions when a company has excess working capital as of the valuation date, which could lead to an upward adjustment to the value of the company. A simple approach to determine whether an adjustment to value for excess working capital is appropriate is to determine the company’s historical working capital levels. If a company has had net working capital levels of approximately 15% of sales over the past five years, it can be reasonably estimated that the company will continue to require that same level of working capital to support future sales. Therefore, it would be appropriate to add any working capital in excess of 15% of sales as of the valuation date to the determined company value as excess working capital – essentially a non-operating asset. A related adjustment may be made that would reduce the company’s value for deficient working capital if the company had a net working capital balance below its historical levels as of the valuation date.
As with many valuation topics, there is no cookie-cutter answer to deal with working capital. The important thing to remember is that net working capital balances need to be considered in any business acquisition and that delivering a company without sufficient working capital will lower its value.
A transaction can be structured in a number of different ways that may result in a buyer assuming all or none of the net working capital of the acquired business, but sellers need to be cognizant that this will impact the purchase price. The seller should end up with the same value, whether it is composed entirely of cash or of a combination of cash and retained assets.
Contact Corrigan Krause to arrange a meeting with our business valuation experts and ensure that you approach an important transaction with confidence.