Working capital, inventory and what the price includes

Most asking prices and offers describe the value of the business as a working operation, before cash and debt are taken into account. Finance people call this enterprise value. What the seller actually receives is different. Add any cash left in the business and take off any debt, and you reach the equity value. The price is then adjusted up or down if the business is handed over with more or less working capital than normal. That final figure is much closer to the amount that moves between bank accounts.

Small business listings often skip this. An asking price may or may not include stock, may assume the seller keeps the cash and repays the loans, or may say nothing either way. Do not assume. Ask what the price includes, and write the answer into your offer.

Working capital is the money tied up in running the business from day to day. In a deal it is usually measured as:

• receivables (debtors in the UK): money customers owe the business
• plus inventory (stock in the UK): goods held for sale and the materials to make them
• plus prepayments: costs paid in advance, such as insurance
• minus payables (creditors in the UK): money the business owes suppliers
• minus accruals: costs incurred but not yet invoiced or paid
• minus customer prepayments and deferred revenue: money received for goods or services not yet delivered

Cash and debt are normally left out of this calculation, because they are dealt with separately.

Every business needs some working capital to function. A wholesaler pays its suppliers before its customers pay it. A builder buys materials weeks before sending an invoice. If you buy a business with that working capital stripped out, you must put in your own money on the first day just to keep it running. That money is part of the real price, even though it never appears in the offer.

The peg, sometimes called the working capital target, is the level of working capital the seller agrees to leave in the business at completion (closing in the US). It is often set by looking at month-end working capital over the past year and taking an average, which smooths out seasonal swings.

At completion, working capital is estimated, then measured properly once the final figures are available. If it comes in below the peg, the price falls by the shortfall. If it comes in above, the price rises by the excess. Some agreements allow a small band either side of the peg before any adjustment is made, so that minor differences are not worth arguing over.

A fictional example shows how the pieces fit together. Wrenmoor Trade Supplies, a UK distributor, is sold for £2,000,000 on a cash-free, debt-free basis with a working capital peg of £300,000. At completion:

• working capital measures £260,000, so the price falls by £40,000
• the business holds £80,000 of cash, which stays in the business, so the seller is paid for it
• a £150,000 bank loan and a £30,000 finance lease, £180,000 in total, are repaid out of the price

The seller receives £2,000,000, less £40,000, plus £80,000, less £180,000: £1,860,000. In total you pay £2,040,000, of which £180,000 goes to the lenders. In return you own a debt-free business holding £80,000 of cash and working capital £40,000 below normal. That is the same as paying £2,000,000 for the business in its normal state, which is what you agreed.

Some deals instead require the seller to leave a set amount of cash in the business, such as till floats or a minimum operating balance, and count it as part of working capital. That works too, as long as it is written down.

Disagreements over working capital tend to start in one of four places.

• Seasonality. If the business peaks in the autumn and completion is in the spring, working capital on the day may look very different from the yearly average. Set the peg with the completion date in mind.
• Growth. A growing business needs more working capital each month. An average of the past year may be too low for the business you are actually taking on.
• Definitions. Decide line by line what is in and what is out. Tax on profits, staff bonuses, balances owed to or by the owner and deferred revenue are frequent sources of argument, so name each one.
• Behaviour before completion. A seller who delays paying suppliers, or presses customers to pay early, can take cash out while working capital drops. A properly measured peg catches this. A vague one does not. See payables stretched ahead of a sale and customer prepayments already spent.

Put the method in the letter of intent: how working capital will be measured, the peg or how it will be set, the line items it includes, who prepares the completion figures and by when, and how disagreements will be resolved, often by referral to an independent accountant.

There are two broad ways to settle these figures.

With completion accounts, usually called closing accounts or a post-closing purchase price adjustment in the US, the price is adjusted after completion once the actual working capital, cash and debt on the completion date are known. It is precise, but it takes time and leaves room for dispute.

A locked box, used mainly when shares are sold and far more common in the UK and Europe than in the US, fixes the price by reference to a balance sheet at an earlier date. The seller promises that no value leaves the business for their benefit between that date and completion, such as dividends, bonuses or unusual fees. There is no adjustment afterwards, so you need confidence in that earlier balance sheet and a clear list of what counts as leakage. You are most likely to meet a locked box when a sale is run as an auction between several buyers.

Inventory is the item most often left outside the headline price in smaller deals. Listings in the UK and Australia often show "plus SAV", meaning stock at valuation is added to the price once it has been counted. US listings often state whether inventory is included in the asking price or sold on top. When inventory is paid for separately, three words decide the number.

Counted. Stock is counted shortly before completion, ideally with you or someone you trust present. Agree the date, the method and who carries it out.

At cost. Stock is valued at what the business paid for it, not at what it sells for. Agree what cost includes, such as the supplier price alone or also freight, import duties and packaging, and check the stock records against supplier invoices.

Saleable. Slow-moving, out-of-season, damaged, expired or discontinued stock should be excluded or written down to what it can realistically fetch. See ageing or written-down stock.

Another fictional example. Brackenholt Outdoor Goods, a US ecommerce retailer, is listed at $900,000 plus inventory, which the listing puts at $200,000 at cost. The count before completion finds $170,000 at cost on hand. Of that, $20,000 at cost is last season's stock that only sells at a loss, and the two sides agree to value it at $5,000. The inventory payment is $155,000, making a total of $1,055,000 rather than the $1,100,000 the listing implied.

For ecommerce businesses, check stock held in third-party warehouses and fulfilment centres, goods in transit and deposits already paid to suppliers for future orders. Each should be counted once, and only once.

Two points link inventory to valuation. First, if you enter inventory at cost in Loupe's valuation tool (the field appears for ecommerce, retail and distribution businesses), it is shown as an addition to the indicative value rather than blended into the multiple, because stock is so often priced and paid for separately. Second, if inventory is paid for separately, make sure it is not also counted inside the working capital peg, or you will pay for the same stock twice.

Offers for established businesses are commonly made on a cash-free, debt-free basis. The seller keeps the cash, or is paid for any cash left behind, and clears the debt, so the price reflects the operating business alone.

The difficulty lies in defining debt. The obvious items are bank loans, overdrafts, finance leases, hire purchase agreements (equipment finance in the US) and loans from the owner or their family. Less obvious items, often called debt-like items, can be just as real:

• tax owed for periods before completion
• bonuses, commissions or holiday pay (accrued vacation in the US) earned but not yet paid
• customer deposits for work not yet done
• supplier balances overdue beyond normal terms
• rent deferred under a payment holiday
• known claims or warranty repairs not yet settled

Some of these can reasonably be treated either as debt or as part of working capital. What matters is that each one is counted in one place, not in two places and not left out. Agree the list in writing.

Many smaller acquisitions are asset purchases rather than share purchases (stock purchases in the US). In a typical asset purchase you buy the goodwill, equipment, fixtures, intellectual property and often the inventory. The seller usually keeps the cash, the receivables and the payables, collects what customers owe and pays its own suppliers.

This is simpler, but it means you start with no receivables. In the first weeks you pay staff, suppliers and rent before customers pay you for the work you have done. You need cash for that from the first day. Build it into your funding plan and ask your lender whether a working capital facility can sit alongside the acquisition loan. Financing an acquisition covers the options.

In a share purchase, working capital usually comes across with the company, which is why the peg matters more there. The right structure depends on tax, liabilities and contracts, so take advice from an accountant and a lawyer before you choose one.

Use these lists as a starting point when you ask a seller what their price covers. Each item you agree should end up in a schedule to the purchase agreement.

Usually included, but confirm

• goodwill, the trading name and customer lists
• equipment, fixtures, fittings and tools, listed item by item
• vehicles, including whether any are still on finance
• intellectual property: trademarks, designs, written content, software and code
• domains, websites, social media accounts, marketplace seller accounts and email lists
• the benefit of customer and supplier contracts, subject to any consents needed
• phone numbers, and licences and permits where they can transfer
• documented processes, templates and the data held in the business's systems

Often excluded or dealt with separately

• inventory, where the price is quoted plus stock
• cash and bank balances
• receivables and payables, in an asset purchase
• freehold property (owned real estate in the US), which is usually sold or let separately
• deposits held by landlords, utilities and suppliers
• balances held back by payment processors and marketplaces
• tax refunds due for periods before completion
• the owner's personal items, including vehicles or equipment used privately

Worth asking about specifically

• equipment that is leased or rented rather than owned
• software licences and subscriptions that cannot be transferred
• stock held on consignment or equipment owned by a supplier
• anything the owner uses in the business but owns personally, such as a van, a domain or a trademark

Before you sign, check that the letter of intent answers these questions in plain words:

• Is the price on a cash-free, debt-free basis, and what counts as debt?
• Does it include a normal level of working capital, and how will that be measured and adjusted?
• Is inventory included in the price, or added at cost after a count, and how is unsaleable stock treated?
• Which assets are included and which are excluded?
• Who prepares the completion figures, by when, and how are disputes resolved?
• Is any part of the price held in escrow or held back until the figures are final?

Your answers carry through into the purchase agreement and into diligence, where each figure is tested. Due diligence: what to check and in what order explains where they fit in the sequence.