“Net working capital” is your “current assets” (saleable inventory and accounts receivable) less your “current liabilities” (accounts payable). Nearly all financial sponsors will expect that you leave behind enough net working capital to continue to sustain the business (in other words, they do not expect to put more cash into the company to sustain its current operations).
The problem is that this working capital represents CASH THAT YOU INVESTED IN YOUR BUSINESS that you won’t be repaid in the sale. You bought the raw materials, you paid all of the out-of-pocket costs to produce the finished goods (both in inventory and sold to customers), and those receivables should be yours!
There is no firm practice regarding how to measure how much net working capital a business should have at any given time. The most common practice is to look at your balance sheet over the twelve months leading up to the sale (or when the valuation is decided), take the monthly average, and (with possible adjustments if the business is growing or declining) use that average to adjust the purchase price up or down depending on how much net working capital is left with the busines at closing.
But you can and should proactively manage your working capital so that your business runs more efficiently leading up to a sale. Doing so will prove to an acquirer that your business is sustainable with less working capital investment – with less cash tied up in inventory – but you must reset your business sufficiently in advance of a sale to prove to an acquirer that your business can continue to grow without boxes of money sitting on your shelves.
The results can be staggering. Inventory “turns” is a measure of a company’s annual sales divided by its average inventory. In industrial companies, ten (10) inventory “turns” is fairly standard. So for a business that generates $30 million in revenue, inventory at any given time will approximate $3 million. But what if you could move your business to “just-in’time” fulfillment? World-class companies can operate as efficiently as 50 “turns” (or, put differently, with 1 week of inventory on hand). If the business in our example could move from 10 to 50 turns, it’s inventory on hand at any given time would move from $3 million to $600,000. That’s $2.4 million in cash that is no longer tied up in raw materials or finished goods that could be returned to shareholders, used to pay down debt, purchase additional equipment, or expand your factory. If you don’t migrate your business to more efficient inventory management before a sale, that $2.4 million will belong to your buyer – because you’ve not proven that you can manage your business with less inventory investment.
In our example, the $30 million industrials company likely generates 15% EBITDA margin (or $4.5 million). If we assume that the business is sold for 5x its $4.5 million in EBITDA, or $22.5 million, poor inventory management means that the sellers have sacrificed 11% of their return (because they left $2.4 million in excess inventory in the business.
We can show you how to manage your inventory more efficiently. We can show you how to negotiate with your customers and your suppliers to ensure that your cash isn’t tied up on your shelves gathering dust. But in order to convince an acquirer that your business can run more efficiently, we need to begin this effort 6-12 months (or more) ahead of a potential sale.