By David McCully

Business owners and C-level executives understand the value of managing working capital effectively. If you are considering selling a business in the foreseeable future, working capital management is not just a good idea, it is a critical step to realizing the business’s maximum value upon your exit.

Plans for the sale of a business should begin when you make the initial investment, but realizing the return on that investment often takes many years. When the end zone is in sight, solid execution of a working capital strategy can have a positive impact on the cash realized upon exit.

When planning for an exit, solid working capital management practices can pay back in many ways. Buyers of a business will look at working capital over a historical period and will typically require sellers to leave a normal amount of working capital in the business after the sale. That being said, the seller’s goal is to demonstrate to the buyer that normal working capital is as low as possible.

Below are just a few of the tangible benefits that may be realized with short-term and long-term working capital management goals and techniques.

Improved Free Cash Flow

Not to overstate the obvious, but effective working capital management can free up cash and generate more earnings today. This is particularly important in tight credit markets like we have seen in the recent past. A continuous improvement program focused on cash management, accounts receivable performance and inventory management is part of a fundamental business management program.

There may be some low-hanging fruit, but the path to success is a disciplined approach that challenges management to improve the working capital metrics every day. Development of defined targets and meaningful scoreboards are needed to monitor improvements.

Positive Impact on Valuation

Business transactions are almost always valued based on a multiple of earnings. Improved profits as a result of successful working capital management will only increase the valuation of the business upon exit.

Realizing Exit Proceeds Using Working Capital

Reducing working capital also will reduce the amount of value left behind after the business is sold.

In general, purchase agreements will specify that the purchase price will be adjusted based on the actual working capital that exists on the closing date versus a predetermined working capital peg that is negotiated. That peg is generally set based on an analysis of the historical trend of operating results.

The buyer will typically attempt to aggressively discount one-off items and impaired assets. Buyers also will frequently use defined terms in the purchase agreement to manage working capital adjustments after closing.

Below are suggested tactics sellers may employ to help realize full value for the transaction when working capital clauses are settled after closing:

• Make sure working capital pegs are clearly defined in dollar terms in the purchase agreement. Percentage of sales and/or clauses stating “normal working” capital can create surprises.
  
• As the seller, develop your own computations of “normal working capital,” share them with the buyer during due diligence and make sure that concept is ironed out and included in the definitive agreement.
  
• Many sellers present historical management financial statements on a basis other than generally accepted accounting principles. Make sure working capital pegs in the agreement define that adjustments are made on a basis consistent with historical accounting practices.
  
• If the business has excess cash, take distributions or dividends before the company goes on the market to demonstrate that those amounts are truly excess cash and not a part of normal working capital.
• Buyers will seldom pay for stale receivables. Set an aggressive plan to collect bad debts and/or settle those amounts with your customers before the transaction is complete.
• Sell excess/obsolete inventory before the business is offered for sale. It will normally be severely discounted in the buyer’s evaluation.
• Sell all idle assets or those that are not a core part of the business. It is better for you to receive the cash than the buyer.
• Make sure you clearly define methods used by the company to reserve for inventory, warranties, sales returns and bad debts during the due diligence process to stave off differences of opinion after closing. Post-closing arguments over these items can be contentious, at best.

Selling a business can be a life event; discipline and planning can help make it a positive one.

For more information on this issue or related matters, please contact your BKD advisor.