Deciphering a Business Valuation may take an experienced analyst.
General Definition:
{Current assets – Current Liabilities = Net Working Capital}
In most cases, the valuation of a business does not include the net working capital of the business at the time of the valuation. Working capital is often excluded from valuations so that business values can be compared to other similar businesses without the need to adjust for working capital. If 2 businesses are identical except one has $1,000,000 in excess cash it won’t affect the valuation comparison because the excess cash is not in the valuation price for the businesses.
However, the working capital can affect the actual selling price of a particular business if the working capital is included in the sale.
Example:
Let’s say Business A is valued at $5,000,000 and business B is valued at $5,000,000, both without working capital. If business A has $700,000 in net working capital and business B has $1,500,000 in net working capital, and the buyer wants to buy the working capital with the business, then business A will sell for $5,700,000 and business B will sell for $6,500,000 even though both were valued at $5,000,000.
Many buyers want to buy a business with adequate or normal working capital. By doing this the buyer has a set amount of capital to raise that allows them to purchase the business. This capital to buy the businesses is likely long-term capital. By including working capital in the purchase, after the sale, the business can operate on the purchased working capital.
The larger the transaction the more likely that working capital will be included in the business sale. The working capital target number (i.e., the amount specified in the LOI to be included in the purchase price) is an important negotiated element of a deal. In the LOI it might be a dollar amount or often an agreed to formula (since the working capital moves virtually every day the business is open) to use to get to a working capital number at closing. Make sure all elements of the working capital calculation is defined and understood.
Common Working Capital Elements
(with notes on the tricky ones)
Assets
Cash and cash equivalents
Accounts receivables
Inventory
Deposits (Deposits business has at vendors or other i.e., tax deposits, lease deposits, etc)
Work-in-Progress (Does your accounting system account for this properly? WIP can also be a liability depending on billing practices.)
Liabilities
Accounts payable
Accrued payroll
Vacation owed employees
Gift certificates (Does your accounting system track?)
Warranties (Outstanding for products or services)
Prepaid service or maintenance agreements
Deposits from customersThe vast majority of business purchases are defined as “asset” purchases. On some occasions, a buyer will actually buy the stock of the corporation. For our purposes here we will outline an Asset Purchase transaction showing what the buyer obtains when buying a business. (For discussion purposes only. This is NOT legal or accounting advice.)
Asset Purchase
An asset purchase is a method of acquiring a business that specifically identifies the assets and liabilities that the buyer is purchasing or assuming. Most business owners own their assets inside of a corporation and the business owner actually owns the Stock in the corporation and does not own the assets directly. The corporation owns the assets and the business owner owns the stock. A buyer typically forms their own legal entity (LLC, S corp, etc) to purchase the assets from the seller’s corporation.
2 Types of Commonly Purchased Assets
Typical tangible assets include inventory, equipment, machines, vehicles, furniture, computers, fixtures, etc. Typical intangible assets include business name, goodwill, customer lists, contracts, non-compete agreements, phone numbers, websites, trained employees, etc. Asking prices normally include all the Tangible and Intangible business assets (unless otherwise identified).
Exceptions
Cash and cash equivalents on hand and in checking or investment accounts, accounts receivable, prepaid items and deposits. Also included are any items in the seller’s corporation that are not used by the business (ex., personal cars, vacation homes, etc.).
Typical Liabilities Retained by the Seller
Accounts Payable and all debts.
Typical Liabilities Assumed by the Buyer
Most buyers want the business to remain in the same location and will want to have the facility lease put in their name. Any contracts where the future benefit goes to the buyer. For instance, Yellow Page Advertising may be an annual contract to be paid monthly. The buyer would assume the remainder of contract payments due after closing. Buyer will want to keep the customer sales. Often times the business has leases for equipment that the buyer will need to assume. These leases are common. The most common are the facility lease and a postage machine lease but there are many others: Brake machines in auto shops, printing presses in print shops, vehicles in delivery businesses, etc. Buyers should make certain they understand what assets they are buying and what liabilities they are assuming. Buyers should make certain that any liabilities to be assumed or assets not included are clearly identified prior to or at closing.
Real Estate
Sometimes the owner of the business corporation also owns the real estate personally and the corporation pays rent to the owner. This appears to be moving money from one pocket to another but is often done for tax purposes. When the real estate is available for sale from the same owner as the business it should be identified. Should buyer purchase the business and the real estate under these conditions the transaction will actually appear to be two transactions. Concurrently buyer would buy the assets of the business from the seller’s corporation and purchase the real estate from the seller personally.
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Mr. Elliott is Managing Director of Sunbelt Texas Business Sales & Acquisitions with more than 20 years experience in mergers, acquisitions and business broker. Mr. Elliott purchased Sunbelt Houston in 1996 and has managed the sale of over 500 companies from very small businesses to companies with revenue of more than $30,000,000. Mr. Elliot has provided Business Broker and merger and acquisition adviser services to privately held business in Houston, Austin, San Antonio and throughout Texas.
Over a 20 year career, he has handled a wide range of industries including manufacturing, distribution, medical, machining, construction, and contractors. Mr. Elliott has completed transactions with Private Equity Groups, strategic buyers and a wide range of regional companies executed plans to grow through acquisitions.
Mr. Elliott has been recognized as a “Thought Leader” by Sunbelt Business Brokers Global Network. Mr. Elliott is frequently interviewed in various media and is considered an expert in the field of buying and selling privately held businesses.
Mr. Elliott has received the professional designations of Certified Business Intermediary (CBI) and Master Merger & Acquisitions Intermediary (MMAI).