What Enterprise Value Includes at Closing
Business owners often assume the agreed enterprise value represents the amount they will receive at closing. However, enterprise value is only the starting point. In most M&A transactions, buyers value a business based primarily on its expected future earnings and cash flows, discounted for risk. Buyers also expect the operating assets necessary to generate those earnings.
This relationship creates an important connection between enterprise value and working capital. Most lower middle market transactions occur on a cash-free, debt-free basis. Therefore, the seller generally retains excess cash and remains responsible for indebtedness at closing. The buyer, however, still expects to receive a business capable of operating normally after the transaction. That expectation includes an appropriate level of working capital.
Working capital generally consists of operating current assets less operating current liabilities. Depending on the business, these accounts may include receivables, inventory, payables, and accrued expenses. Without sufficient working capital, the buyer could immediately need additional cash to operate the business. Conversely, excess working capital could transfer additional value beyond the negotiated economics.
For this reason, buyers and sellers typically establish a working capital target before closing. The target represents the normalized working capital required to support ordinary business operations. Historical working capital often provides the starting point for this analysis. Yet seasonality, growth, unusual balances, and changing business conditions may require adjustments.
The parties should also define exactly which accounts enter the calculation. Otherwise, disagreements may arise over cash, debt-like items, customer deposits, prepaid expenses, or other balances. At closing, the parties compare actual working capital with the agreed target. A shortfall generally reduces the seller’s proceeds, while an excess generally increases them.
This adjustment does not necessarily change enterprise value. Instead, it reconciles the balance sheet delivered at closing with the assumptions underlying the negotiated purchase price. Accordingly, sellers should understand enterprise value and working capital before signing a Letter of Intent. Waiting until due diligence may create unexpected changes to anticipated proceeds.
An experienced M&A advisor will help establish the appropriate working capital methodology early. The advisor may also coordinate the analysis with the seller’s accounting and legal professionals. Clear definitions prevent working capital from becoming a closing surprise. They also ensure the buyer receives the operating balance sheet contemplated by the transaction.
