Working capital – just what exactly is normal?

You’ve agreed the price for the shares in your business on a ‘debt-free, cash-free’ basis; you’ve shaken hands on the deal, even agreed a date for completion and then the buyer slips in the phrase ‘with a normal level of working capital’. What exactly does this mean and how is this ‘normal’ level calculated?

What the purchaser is looking for is protection that the working capital in the run-up to the completion (essentially the debtors plus stock minus trade creditors and accruals) has not been stripped from the business. This could include, for example, creditors not being paid, stocks being run down and the collection of debtors accelerated, with the resulting cash that is generated taken out by the vendor on completion through that ‘cash-free, debt-free’ mechanism. (In other words, that the cash that is in the bank on completion is paid to the vendor on top of any agreed purchase price, but any agreed debt, such as an overdraft, is deducted from the purchase price).

By stressing that working capital is at a ‘normal’ level on completion, the purchaser expects that debtor and creditor days have been maintained as normal, as too have stock levels, in the months running up to completion.

There is no science to the calculation of working capital; it is more a case of scheduling out the level of debtors plus stock less trade creditors and accruals historically and rolling the exercise forward from your cashflow projections into the period post-completion.

In terms of what time period you should cover, start with a year either side of completion to pick up any seasonal fluctuations. If your business is not seasonal, then the typical (or ‘normal’) level of working capital will be relatively self-evident; if your business is seasonal, you may have problems.

Other influencing factors to consider include the payment of rebates, commissions and overiders. Depending on your industry, these may not be paid on a regular basis and so could well distort the profile of your working capital.

Some advisors often calculate an average of working capital over, say, a twelve month period and use this as a basis from which deviations on completion are calculated.

It is the interpretation of the numbers calculated that are of crucial importance as, for a cyclical business, it is entirely normal for working capital to fluctuate; what the subsequent agreement should focus on is an adjustment mechanism to compensate either party for deviations from the underlying or normal level, whether the underlying level be positive or negative.

So, for example, if the calculations show a ‘normal’ or expected level of working capital to be £500,000, then for every £1 that the actual figure at completion differs from this ‘normal’ level, the purchaser will pay the vendor (if the actual figure exceeds) or will receive from the vendor (if the figure subsequently calculated falls below). Some purchasers and their advisors will merely seek to argue that the absolute level of working capital (if negative) should be deducted from the purchase price; taking such a view is far too simplistic.

So what can you do to protect and optimise your position?

  • Schedule out your historic and projected working capital position so as to understand what the likely position will be at completion
  • Raise the issue with the purchaser and their advisors once the price has been agreed (without sharing your calculations at this stage) to understand their likely stances; far better to have an indication of the potential battle and potential adjustment at this stage rather than at the eleventh hour
  • Crucially, let your advisors lead here – they can be objective and dispassionate.
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