(This interview has been condensed and edited for clarity)
Santosh Mohanan has been active in the restoration industry for over 16 years and during this time, contributed to Canstar Restorations’ growth from a 6 million dollar company to 50 million. Santosh was responsible for the finance, administration, and IT departments. Today Santosh is speaking on a commonly misunderstood topic during a company sale – Working Capital.
Let’s talk about a very misunderstood concept during a business sale – Working capital. First – could you please offer a brief description of working capital?
In simple terms, working capital is what the business needs in cash after a sale in order to continue with the new ownership. In simple terms, working capital is strictly a cash transaction. How much cash or available current assets do you have at the moment that will be able to fund the operations through your company’s current liabilities? An example of a current asset would be accounts receivable. Your company truck is too long-term in order to count as a current asset.
Based on that, the working capital that the old owner keeps is cash, as well as a few long-term liabilities. For example, if you have $100 in cash at the bank and you owe $20 for a car loan and $30 for another equipment loan, the buyer will give you the $100 minus $20, minus $30, on the assumption that you as the seller will pay off those incumbrances before you transfer the company and assets over to them.
When the purchase price is agreed to, there is always a portion of that purchase price that working capital has been figured into. Let’s say the IRR comes up and it says the working capital has to be $1 million dollars but at the end of the transaction when the final numbers are done, the real working capital ends up being $1.8 million. The seller will get $1.8 million even though the original estimate was $1 million. This benefits the buyer because the buyer has fewer liabilities and more accounts receivable (AR) with their new company.
Why is Working Capital often misunderstood?
Sellers usually think that when they sell the company all the assets will still be theirs. But, they don’t realize that you can’t go into a Mergers and Acquisitions (M&A) transaction thinking that you will get the vehicles or the accounts receivable because those will go with the company. You, as the seller, just get cash. We have to look at working capital from both a finance and an accounting perspective and find the happy medium between the two.
How is Working Capital calculated during a company sale and when is this figured? Is this handled differently in a large company sale and a smaller company – especially in figuring who pays the amount?
The basic principles behind it are the same, it changes based on what elements go into it. I think the biggest difference is if people understand what the definition of working capital is, it makes life a lot easier for them. Understanding the definition of working capital is very important when you decide to sell the company.
Start cleaning up your books! Start deciding what it is you want to show as working capital because if you don’t, it’s going to feel very insulting when you’re sitting through the due diligence process with the M&A specialist.
I would also advise people to start reading about working capital because the Restoration Industry is going through a maturing process as well right now and buyers are starting to view the industry as a real business and an essential need.
What steps should a financial team take today to help create clean books and numbers, in anticipation of future mergers or acquisitions?
The first step, I think, is that sometimes loyalty clouds innovation even though I am a big fan of loyal employees. But loyalty can sometimes cloud outside thinking. It is always a great idea to invest in an external third-party source when you are going through the M&A process. Whether it’s at the beginning or in the middle of the process, just get an external third party involved and have your internal teamwork with the external team.
Unfortunately, the following scenario plays out in a lot of companies. They bring in an M&A team, and they run a complete working capital scenario. Then the internal team is brought in when it feels right, but by this point, the M&A team has done most of the legwork without having consistent communications with the internal team – and now the internal team feels insecure. The solution for this scenario is to bring them all together as soon as possible. Don’t make the whole company part of the internal team but choose two key people who understand the purpose of this transaction. These key people should have been a part of your growth and are able to give the M&A team the business answers that they are looking for.
The second step is to start the selling process while keeping the end goal in mind. Start making a list and write everything down (many owners have lived their lifestyle in and through the company and don’t realize that those vacations, personal expenses they’ve paid for with the company, etc. will come out eventually). Spend the money and hire an external person to rip all the data apart, and combine it. As a seller, you need to keep in mind that the process of selling is very painful, cold, and sometimes insulting. If you make sure you have collected all the data, it will make your life and this process a lot more simple. This is the end goal you are after.
The third step (and one of the biggest things I think that helped [Canstar] a lot) is to have an outside circle where you can discuss the selling process. Jay [Dargatz] worked with Business Mentors and was a part of Tech Canada. Through these two organizations, he met a lot of people who were both a part of the restoration industry as well as general business. Having people in another industry that had already gone through the same thing he was going through was very helpful as they were able to coach him and guide him.
The fourth step is to have a timeframe. What date or time frame would you like the transaction complete? Right now, the US is hopping with M&A but at the end of the day, what are you giving up? There is always an opportunity cost that you are paying. These four steps should help business owners understand how working capital plays in most business transitions. I recommend that the discussion start early in the process rather than waiting until the end.