There are a variety of ways to handle the sale of working capital when buying or selling a business. In accounting terms, working capital is the difference between current assets and current liabilities. By working capital, I’m generally referring to the sale of inventory and accounts receivable when a business is sold. Here is a short primer on the most common ways the purchase of working capital is handled in the sale of a business.
Working Capital Sold Individually
When an individual buyer purchases a smaller business, the company is usually sold free of any debt. The individual working capital components, such as inventory and accounts receivable, are purchased separately at cost. The seller normally keeps the cash balances used in the business.
Inventory purchases should be handled carefully. For instance, a purchaser does not want to buy too much inventory or purchase products which are obsolete. A prudent buyer should determine the inventory requirements of the business independently to eliminate the need to rely on the seller’s judgment. Inventory can either be paid for at the closing or be financed by the seller or a lender.
Buying Accounts Receivable
Companies that sell to other businesses usually have a significant amount of receivables. They generally offer purchase terms to their customers and it is not uncommon for this type of business to carry 30 days worth of receivables. In a sale of this type of business, it is beneficial to both the buyer and seller for the buyer to purchase the accounts receivable. The advantage to the seller is that he no longer has the work of collecting accounts receivable and “chasing” past due accounts. Some clients may become less willing to pay in a timely fashion once they discover that the seller no longer owns the business and cannot use the threat of withholding future purchases in response to slow payment.
For the buyer, there are also several advantages. For example, a seller who no longer owns the business may not be as motivated to preserve the customer relationship as the new owner who wants to maintain the customer base. With nothing to lose, a seller may be more likely to offend a client while pursuing a past due receivable. Buyers also want a seamless transition. They want the client to continue making payments to the same business at the same address.
There are several issues which need to be addressed when negotiating the sale of accounts receivable. What, if anything, should the buyer be paid for collecting the seller’s receivables? Does the buyer bear any of the loss of the uncollected accounts receivable? How will uncollectable debts be treated? In most instances, agreements regarding the sale of accounts receivable call for payments to be applied to the seller’s oldest receivables except in case of a disputed invoice. Once receivables have aged beyond a pre-determined time limit – typically 60 or 90 days – the debt reverts back to the seller who is free to pursue collection. These policies are why delinquent debts are not usually included in a sale of the receivables.
If the business purchase includes inventory or accounts receivable it is common to set caps on the amount that the purchaser is buying. These limits are essential to ensure that the buyer will not run out of money before the closing on the business. If the amount of receivables and inventory to be purchased becomes too large it can either force the seller to extend financing on the excess or the deal may not close.
Net Working Capital
Another way of handling working capital that is popular in larger transactions is for the buyer to purchase all of the current assets (except cash) and to assume all of the current liabilities (except current portion of funded indebtedness). This is commonly referred to as “net working capital”. The parties need to agree on several essential elements such as exactly what components of the current assets and current liabilities are included in net working capital and the level that the buyer is purchasing. They may agree that these should balance out at zero and any difference is adjusted at closing. They may instead agree that the net working capital level being purchased is that which is reported as of a specific balance sheet date with any changes to the net working capital to be adjusted at the closing.
The purchase of working capital is an important element of buying a business. There is usually a significant amount of money tied up in working capital so both parties need to be careful to determine that the approach used will serve their needs. A successful sale requires that both parties believe the terms of the sale of working capital is reasonable.