When a buyer looks at a business they look at the total investment needed in order to make the business function. They compare this total investment to the return they will make – the profit from trading – and assess if the business is a worthwhile prospect to invest in.
A key part of this total investment lies in working capital such as stock and debtors. The more money locked up the lower the return and thus the lower the price they are willing to pay.
Take the following as a simple example:
EBITDA of €500k
A business value multiple of 5
Net working capital of €1m
Amount paid for shares = 5 * €500k – €1m = €1.5m
Also when a potential buyer looks at the growth prospects for a business they will be examining how much they must invest for each extra sale. This consists of the amount of investment tied up in working capital and the ongoing investment needed to grow the business. If this growth consumes a lot of investment, then it lowers the return generated from the incremental growth as a percent of the investment. This makes the business now doubly unattractive as extra cash is tied up in working capital as part of the purchase price and the business is expensive to grow.
To take example of Company A above:
If €1m is set aside to grow the business, and the anticipated sales from that are €5m rather than say €3m then this is a more valuable business to a buyer and that will be reflected in the sale price.
Contrast this with a business which manages its working capital more effectively. Economists consider investment in stock as a measurement of inefficiency. The less locked up the more cash in the bank and the less that is needed to grow the business. More cash in the bank means immediately a higher price and lower cost growth model typically means a higher multiple sale price for the business.
If Company A was able to reduce its working capital from €1m to €500k then the remaining €500k would be in the bank. This cash surplus would be retained by the business seller while at the same time making their company more attractive to buyers.
Lesson: Turn a double hit into a double plus by managing your working capital efficiently.