Working capital and net debt: from price to cash in hand

From enterprise value to the cash you receive

When a buyer says it will pay 4x your normalised EBITDA, it is valuing the business as if it had no cash, no borrowings and a normal amount of working capital. That figure is the enterprise value. What you sell, if you sell shares, is the equity value: the enterprise value adjusted for what the company actually has on its balance sheet at completion.

The bridge from one to the other is usually:

1. Start with the enterprise value, the multiple times normalised profit.
2. Add surplus cash left in the company.
3. Deduct debt, such as bank loans and finance leases.
4. Deduct debt-like items, such as unpaid tax and customer prepayments.
5. Add or deduct the difference between actual working capital and the agreed normal level, the peg.
6. Deduct any amount held back, such as a retention or deferred payment, to arrive at cash at completion.

The multiple itself is covered in how SMEs are valued, and our Singapore SME valuation multiples research shows where owner-operated businesses typically land. This guide is about everything after the multiple.

What does cash-free, debt-free mean?

Cash-free, debt-free means the buyer pays for the business, not for the cash in the bank or the loans against it. In practice you keep the benefit of surplus cash, either by taking it out before completion or by being paid for it, and the company's debts are repaid or deducted from the price.

Not all cash counts as surplus. Buyers commonly argue that some of it must stay in the business:

• Operating cash. A minimum level needed to pay staff and suppliers in the first weeks after completion.
• Cash that belongs to others. Customer deposits, fees collected in advance and money held for third parties sit in the bank account but are owed.
• Trapped cash. Cash held as security deposits or under bank guarantees that cannot be freely used.

Agree what counts as cash in the heads of terms, because it is one of the first places value moves late in a deal.

Debt and debt-like items buyers deduct

Debt is straightforward: bank loans, overdrafts and finance leases are deducted. Debt-like items are amounts that are not borrowings but that the buyer will have to pay out of its own pocket after completion for something that happened before it. These are where most negotiation happens.

Watch for double counting. An item should sit either in working capital or in debt, never in both. Businesses that collect fees in advance, such as education, fitness and subscription services, should expect the treatment of customer prepayments to be the biggest single argument.

Normal working capital and the peg

Working capital is the money tied up in running the business day to day: trade receivables, stock and prepayments, minus trade payables and accruals. Cash, debt and tax are usually excluded, because they are dealt with elsewhere in the bridge.

The buyer expects to receive a normal level of working capital, enough to keep trading without injecting cash. The agreed normal level is the peg, often based on the average over the past twelve months so that seasonal swings even out. At completion:

• if actual working capital is below the peg, the price falls by the shortfall;
• if it is above the peg, the price usually rises by the excess, though some buyers try to cap this.

Three things protect you. First, calculate your own monthly working capital for the last twelve to twenty-four months before buyers do, so you know what normal looks like. Second, resist a peg set off a single high month. Third, keep running the business normally until completion: chasing every debtor and delaying every supplier just before completion is usually reversed through the peg, and it can raise questions in due diligence.

A worked example: from headline price to cash at completion

Illustration only. A business with normalised EBITDA of S$750,000 receives an offer at 4.0x, on a cash-free, debt-free basis with a working capital peg of S$300,000 and a retention of S$200,000 held against warranty claims.

The owner was offered S$3.0m and receives about S$2.45m on the day, roughly 82% of the headline, with up to S$200,000 more when the retention is released. That sits within the typical range: in SME deals, 50% to 85% of the price is usually paid at completion. The figures are before the seller's own adviser and legal fees and any tax. Change the definitions and the result moves: if the buyer had won the argument to treat an extra S$100,000 of cash as operating cash, the owner would receive S$100,000 less, with the multiple unchanged.

Completion accounts or locked box: which is better for you?

There are two common ways to fix the balance sheet figures in the bridge.

Completion accounts. The price is paid at completion on estimates. Accounts are then drawn up as at the completion date, usually by the buyer, and the price is adjusted up or down once they are agreed. Disagreements are usually referred to an independent accountant. The buyer gets precise figures; you carry the risk of the business until completion and wait some time for the final number.

Locked box. The price is fixed by reference to a balance sheet at an earlier date, the locked box date, usually the latest reliable accounts. There is no adjustment after completion. In return you promise that no value leaks out of the company between the locked box date and completion, such as dividends, unusual bonuses or payments to related parties, other than items agreed in advance. Because the buyer takes the profit earned after the locked box date, sellers sometimes ask for a daily amount to compensate for it.

Many owner-operated SMEs end up with completion accounts because their accounts are not prepared to a standard a buyer will lock a price to. Getting your management accounts monthly, reconciled and reviewed for a year or two before a sale makes a locked box, and a calmer completion, more realistic. Our guide to preparing your business for sale covers this.

How to protect your price before you go to market

1. Build your own equity bridge from your latest accounts before marketing, so you know your likely cash at completion.
2. Repay or formalise director and shareholder loans, and clear old balances that will only attract questions.
3. Track monthly working capital for at least twelve months, and understand its seasonal pattern.
4. Decide how you will argue the treatment of customer prepayments and deferred revenue, with evidence of the cost to deliver them.
5. Make sure the tax provision in your accounts is accurate, since unpaid tax is deducted.
6. Ask for definitions of cash, debt, debt-like items and working capital in the heads of terms, not just the headline price.
7. Have your accountant review the buyer's completion accounts or locked box figures before you agree them.

For a first view of enterprise value, try our business valuation calculator, then work through the bridge above to see what that could mean in cash. How deferred payments, earn-outs and retentions sit on top of this is covered in our guide to deal structures.