The Second Negotiation

Most owners believe the price is settled when the letter of intent is signed. The number is on the page, both sides have agreed to it, and what follows feels like paperwork.

It is not paperwork. A second negotiation follows, and it is fought over a number most owners have never calculated. It does not move the price at a multiple. It moves it dollar for dollar, and it is decided after the owner has stopped thinking about price at all.

That number is the working capital target, and this week is about how it works.

The phrase that carries a blank

Nearly every letter of intent for a privately held business contains some version of the same sentence. The business will be delivered cash free, debt free, with a normal level of working capital.

Owners read the first two terms carefully. They keep their cash, and their debt gets paid off. The third term is the one that matters, and it is almost never given a number in the letter. It reads like a courtesy. It is actually a promise to deliver a specific balance on the day of closing, with the specific balance still to be decided.

Working capital, in this sense, is what the business needs to run on Monday morning. Receivables that customers owe, inventory on the shelf, and expenses paid in advance, less what the business owes its suppliers and the costs it has incurred and not yet paid. Cash is usually left out, because the owner keeps it.

A buyer is paying for a business that operates. A business that operates needs that balance. So the buyer expects it to come with the company, at a normal level, and the price was set on that assumption.

How the target works

Before closing, the two sides agree on a target, usually called the peg. It is most often an average of the monthly working capital balance over the trailing twelve months, adjusted for anything the buyer argues is unusual.

At closing, the actual balance is estimated and compared with the target. If the business arrives with less working capital than the target, the price goes down by the difference. If it arrives with more, the price may go up by the difference, depending on how the agreement is written. Sixty to one hundred twenty days later, the final figures are calculated and the adjustment is settled again.

Here is why it deserves attention. A dollar of earnings is priced at a multiple. A dollar of working capital shortfall comes off the price at one for one. There is no multiple to soften it, and no negotiation left to absorb it, because it happens after the headline number is already agreed.

Where owners lose money on it

Owners rarely lose on the mechanism itself. They lose on four things around it.

The period chosen. A twelve month average sounds neutral. In a seasonal business it is not. The choice of which twelve months, and whether certain months are excluded as unusual, can move the target by a meaningful amount. The side that has done the arithmetic chooses well. The side that has not accepts what is proposed.

The definitions. What counts as working capital is written into the agreement, line by line. Whether aged receivables are included at full value. Whether accrued bonuses and vacation are counted as obligations. Whether customer deposits and prepaid work sit inside the calculation, which, as last week's issue explained, can be a large number in a business with a strong recurring base. Each definition is a small decision. Together they are the price.

The records. A target is only as good as the monthly balances it is computed from. A business that closes its books loosely during the year, or records receivables and payables only at year end, produces a monthly history that a buyer's accountant will rebuild. The rebuilt history will be careful, and it will be careful in the buyer's favor.

The final months. This is the one that catches people. An owner who decides to collect every receivable hard and stretch every payable in the last quarter before closing, in order to take more cash out, does not keep that cash. The working capital balance falls below the target, and the shortfall comes back out of the price. The balance sheet cannot be harvested on the way out. It can only be managed well for long enough that normal is a number the owner chose.

The other side of the same arithmetic

There is a better way to see all of this. A business that turns sales into cash quickly needs less working capital to run. Receivables collected in thirty days instead of sixty. Inventory that turns rather than sits. Payables managed with discipline rather than by whoever shouts loudest.

A business like that has a lower normal level, a buyer has less to fund at closing, and the owner keeps more of what the business produces along the way. None of that requires growth. It requires attention, over several years, to how fast the money comes back.

That is also why this cannot be fixed in the year of the sale. The target is computed from history. Whatever the last twelve or twenty four months show is what gets negotiated.

What to do now

The work is straightforward and it is not quick.

Know your own working capital balance every month, calculated the same way each time, and keep two years of it. Understand your seasonal pattern before anybody else describes it to you. Write off receivables that will not be collected rather than carrying them at full value. Decide, with your own accountant, how deposits, prepaid work and accrued obligations are treated, and treat them that way consistently.

Then, when a letter of intent arrives, negotiate the target in the letter rather than after it. Once the headline price is signed, the working capital target is the only number left on the table, and the side that arrives with the better history usually sets it.

Where to start

If nobody has ever read your company the way a buyer will, the value gap estimate is the cheapest place to begin. You answer questions about the business in plain language, it takes about fifteen minutes, and it asks for no financial statements. I review every one personally and send you the result.