Working capital sits beside the price, and a buyer will ask about it

The asking price for a business is set on its earnings, and it may not cover the money tied up in stock and in customers who have not paid yet. That money still has to be dealt with at settlement. If nobody has thought about it until the contract arrives, it turns into an argument late in the deal, when arguments are at their dearest.

None of this is complicated. It is just left out of the conversation about price.

What working capital is

In a small business, working capital is the money you need tied up in the business for it to run. Stock on the shelves or in the yard. Debtors, meaning customers who owe you for work already done. Less creditors, meaning the suppliers you owe.

It moves every week. It swings with the season. And it is separate from the earnings a buyer is paying a multiple of.

An illustrative example, round figures only. A business carries $150,000 of stock at cost, is owed $100,000 by customers and owes suppliers $80,000. Its working capital is $170,000. That money is real, and it has to go somewhere at settlement.

Stock, counted and paid for at settlement

In an asset sale, the contract decides how stock is handled. Sprintlaw lists whether stock is included in the fixed price or valued separately among the common points in a purchase price clause. A business advertised at a price "plus stock" is the second kind.

Where stock is paid for separately, it is counted close to settlement. LegalVision notes that it is common for a stocktake to happen within a few days before completion, and that the parties may agree to have an independent valuer conduct it instead.

Three things decide what you are paid for it:

• The value. Business Queensland's valuation checklist asks for the book value of the stock, not the retail selling price. Expect to be paid at cost, not at what it sells for.
• The dead stock. The same checklist asks what proportion of the stock is obsolete or unsellable. LegalVision says obsolete or perishable stock has to be negotiated with the buyer. A buyer will not pay full value for it.
• A cap. LegalVision notes that buyers can ask for a maximum sum for stock, so they do not have to buy stock above that amount. Building stock up before a sale can leave you holding the excess.

Debtors and creditors in an asset sale

In an asset sale the buyer buys the assets the contract lists, and nothing more. Sprintlaw lists cash at bank and accounts receivable, unless expressly included, among the things an asset sale commonly excludes. Astris Law describes the liabilities that pass in an asset sale as generally only those the buyer agrees to take on, though some follow the staff or the assets by law. Staff entitlements are their own subject, covered in what happens to staff entitlements when you sell.

So unless the contract says otherwise, you keep your debtors and your creditors. After settlement you collect what customers owe you for work done before the date, and you pay your own suppliers.

Two practical points follow. Your customers are now dealing with the new owner, so collecting from them is easier if the contract says how payments that land in the buyer's account are passed back to you. And you need cash on hand after settlement to pay suppliers before your last debtors pay you.

For the buyer, the effect is the other way round. They take over the stock but none of the money owed to the business. From the first day they pay wages and suppliers while waiting for their own first invoices to be paid. That is working capital they have to fund on top of the price. Business Queensland notes that employee buyers may find it harder to secure the full finance for the purchase price and the working capital, which is the same gap seen from the buyer's side.

In a share sale, it comes with the company

A share sale is different. Astris Law puts it simply: a share sale transfers the company with everything inside it, known and unknown. The stock, the debtors, the creditors and the cash all stay in the company, so they all pass to the buyer.

That is why the price has to be adjusted for them. HLB Mann Judd, an accounting firm, describes transactions as commonly priced on a cash free, debt free basis, assuming normal working capital. The working capital adjustment is worked out against a target amount the parties negotiate. That target is what people mean by a peg.

If the business is handed over with less working capital than the target, the price comes down. If it has more, the price goes up. Hamilton Locke, a law firm, describes completion accounts as fixing a target level of working capital the company must have on completion. The alternative it describes is a locked box: a fixed price, with the seller promising that no value leaks out of the company before completion.

Where the target is set matters more than the mechanism. A target struck from your busiest month and measured on your quietest one costs you money for nothing more than the calendar. Ask which months it is drawn from, and why.

Why a buyer cares

A buyer is paying for earnings. Working capital is what it takes to produce them. A business that needs $170,000 tied up in stock and customers to make its profit needs that whoever owns it.

If a seller runs the stock down, chases every debtor and stretches suppliers in the months before settlement, the earnings look the same and the business needs a cash injection the day after. A buyer's accountant looks for that. Business Queensland's valuation checklist asks plainly whether there is working capital or sufficient cash flow.

It sits beside the measures in the eight numbers every buyer checks first, and it is read the same way: known, explained and steady beats perfect.

How to read your own before you list

You can do this from your own accounts, with your accountant's help.

• Pull twelve month end balance sheets. Record stock at cost, debtors and creditors for each month.
• Find your normal. The average of the twelve, the high month and the low month. The gap between high and low is your season.
• Work out debtor days. As an illustration, a business with $1,200,000 of annual sales is selling about $100,000 a month. If customers owe it $150,000, that is about a month and a half of sales waiting to be paid.
• Be honest about the stock. At cost, with the dead stock taken out.
• List what you owe that is not a supplier. Tax and super owing are liabilities a buyer's accountant will find, and an ATO payment plan is part of that picture.
• Leave it alone. Do not run stock down or stretch suppliers to dress the figures. It shows.

This is the number beside the price. The price itself is a conversation about earnings, which is what what is my business worth covers. If you want a quick view of how the rest of the business would read to a buyer, the free readiness check runs through twelve things a buyer's accountant and lender test. It runs in your browser and stores nothing.

The contract terms on stock, debtors and any adjustment are for your solicitor to draft and your accountant to check. What you can do before then is know your own figure, so that when a buyer raises it, you already have the answer.