How to get brokers / sellers to understand working capital?

NWC is unfortunately almost always a bit of a contentious point in the negotiations. In many cases, it has become even more so in the post covid era. Because of supply chain issues, many businesses increased their inventory as a hedge against supply shortages. This artificially inflated their inventory levels based on historical norms and, thus, their working capital requirements. Now, this can actually be a two-edged sword. We saw one potential client who doubled his inventory to hedge against supply chain shortages and this turned into a real competitive advantage and his business grew substantially because he had inventory, and his competitors didn't. This created a real valuation dilemma since the doubled inventory allowed him to increase sales, but his argument was that he wanted to be paid for that increase of inventory in the NWC calculation but at the same time, he wanted the positive affect that the increase in sales/profits gave him from that strategy.

Post covid, we've seen two approaches to the NWC calculation. Both are cash free/debt free. One is the traditional average cash free/debt free NWC over the trailing 12 months to adjust out any seasonality or unique material events. The other is to look at what the business was doing in 2019 on a pre-covid basis. We've seen a number of buyers try to price a deal based on the pre-covid financial performance of the business as well as to calculate NWC. In most cases, there is no magic answer. The end result often lies in some negotiated compromise.

There is one other factor to consider. If the business traditionally has a fair amount of receivables that age over let's say 60 days, but the owners pay their bills in net 30 or less (we've had one seller who paid his bills immediately on receipt), there will be an imbalance in NWC and that may need to be a negotiated adjustment to average NWC. Lastly, the simple example to site for sellers who think they should take all of the receivables is this: If you buy a car, the dealer doesn't tell you to push your new car down the road to the gas station because there's no gas in it. The same scenario applies to an appropriate level of receivables to continue to operate the business. The receivables are the gas in the tank. Hope that is helpful for you.

4 years later and I've found this to be a valuable thread. Thanks to all who've added their wisdom and knowledge to this thread. It's helped me submit an LOI on my most recent target. The sellers are taking my offer seriously and we're moving forward in negotiations.