When selling a business, the Net Working Capital requirement can have a big impact on the sale price. Steps must be taken to carefully define the Net Working Capital requirement of a business.

The higher the Net Working Capital target, the lower the goodwill component of the sale price, so it is in the seller’s best interest to justify the lowest Net Working Capital target.

Experienced buyers can often make valuable adjustments from unsuspecting business owners without being called out. Unfortunately, many lawyers and accountants do not appreciate the significance of this and may overlook how important this calculation is, which can cost the seller money.

A widely-adopted method to derive the Net Working Capital target is to take the month-end balances for a period, usually the last 12 months.

Month end balances often include two months’ trade debtors balances, being the current month invoices and the prior month’s invoices waiting payment at the end of the month. This often inflates the average, which benefits the buyers and hurts the seller.

It also restricts the window to close the transaction to a month-end. Otherwise, a mid-month calculation would more than likely produce a lower balance than the target, resulting in the seller having to cover the shortfall relative to the target.

Divest Merge Acquire goes to extra lengths to calculate the average based on daily balances for the past 12 months. Not only does this produce a balance that is usually lower than the month-end peaks, but it allows flexibility to be able to close the transaction at any time during a month.

Many clients have benefited from this practice. It is one of the many ways Divest Merge Acquire adds extra value for its clients.

This article is one of a series being published by Divest Merge Acquire demonstrating ways M&A Advisors can assist business owners optimise their sale outcome.

When selling a business, one area that is often misunderstood is how employee entitlements are treated in a deal and this can cost you money.

Many lawyers and accountants do not fully understand how to calculate these, which can mean the seller loses part of the sale proceeds.

Employee entitlements can be classified in two ways during a sale, as third party debt or net working capital.

The degree to which employee entitlements can be classified as net working capital allows them to be transferred without being treated as a debt adjustment.

Liability items that form part of net working capital are the seller’s friend, as they become credits to reduce the net working capital requirement of the business. The lower the net working capital target, the higher the goodwill component of the purchase price.

Buyers would love all the employee entitlements to be treated as debt, deducting the total amount from the purchase price as a debt adjustment. Unsuspecting business owners can fall prey to this harsh and unfair treatment.

The extent to which employee entitlements are treated as debt, they are a deduction from the purchase price, which then should be mitigated by the implied future tax deduction available, which may be 70%-75% of the gross amount, depending on the company tax rate.

Here is how we recommend mutually fair treatment of the various entitlements
The 3 main element of employee entitlements are annual leave, long service leave and personal leave.

Personal Leave
Firstly, no adjustment should be made for personal leave, which is a contingent liability only. At most, only an indemnity could reasonably be offered to cover a nominated period after completion to the degree that the aggregate of personal leave taken exceeds the net new entitlement.

Annual Leave
The accrued employee annual leave entitlements of an employee:

(1) up to and 4 weeks accrued will be treated as a Working Capital Liability Item; and;
(2) in excess of 4 weeks accrued will be treated as a Third Party Debt and deducted from the purchase price,

Long Service Leave
The accrued long service leave entitlements of an employee:

(a) with less than 10 years’ service to be treated as a Working Capital Liability Item;
(b) with more than or equal to 10 years’ service but less than 15 years:

(i) will be treated as Third Party Debt up to 8.67 accrued weeks; and
(ii) will be treated as a Working Capital Liability Item for amounts in excess of 8.67 accrued weeks; and

(c) with more than or equal to 15 years’ service will be treated as Third Party Debt.

When evaluating the factors that influence business value, attention is often directed toward revenue, customer loyalty, or brand reputationn. But one often-overlooked factor that can quietly chip away at a business’s value is stock.

Inventory, especially when it’s excessive or outdated can be a silent threat. It’s not just about cluttered shelves or full warehouses. Stock levels play a direct role in how a business is perceived, how efficiently it operates and its goodwill value.

Why Too Much Stock Is a Problem

Excess inventory usually builds up due to overordering, inaccurate demand forecasting, or sudden market changes. While it may seem harmless, it can send the wrong message to potential investors. Large amounts of unsold stock may suggest poor planning, outdated systems or weak sales.

High stock levels are often the bane of import/wholesale businesses. It may be necessary to provide stock buffers for security, stock in transit, achieve economic order discounts and cover shipping and supply disruptions. Ordering direct from overseas suppliers has positives and negatives in terms of business value.

The Financial Impact

Idle stock ties up capital that could be used for growth, innovation, or improving operations. It also impacts cash flow, which is the lifeblood of any business.

Even small improvements in inventory management can lead to big gains. For example, a 1% increase in gross margin, achieved by better stock control, can translate into significant added value.

Alternative models may include buying from local wholesalers at higher prices but overall requiring less cash tied up in stock on hand. Although profit margins may be lower, the lower business valuation may be more than offset by less of that value attributed to stock and a higher goodwill component.

Accuracy Matters

When selling a business, buyers and their advisors may want to see accurate historical stock records.

As inventory can have a direct effect on a company’s profit and loss, a purchaser’s advisors will scrutinise the accuracy of the opening and closing stock levels quoted in the financial statements.

Further, transactions that involve a significant amount of inventory, an independent stocktake may be required prior to closing.

Excess stock, ways we can mitigate the effect

If there is a genuinely unnecessarily high level of stock on hand that can be reduced without negatively impacting margins, we can notionally ‘ring-fence’ the excess component and exclude from the business enterprise value. It can then be either purchased at an additional price or allowed to be sold off by the seller before completion. Another option is to allow this stock to be held on consignment by the buyer and paid for at cost when the new owners still it at a profit, resulting in a potential win-win.

What Counts as Excess?

It’s common for purchases to negotiate a lower cost price on excess or aged inventory. Buyers often consider stock held for more than 6 to 12 months as “slow-moving” or “dead.” Identifying these items early allows businesses to clear them out, free up space, and avoid negotiations.

A Smarter Approach to Inventory

Streamlining inventory isn’t just about tidying up, it’s a strategic move. It improves efficiency, boosts cash flow and sends a clear message that the business is well-run. And when it comes time to sell, that can make all the difference.

Managing stock wisely and accurately is more than good housekeeping, it’s a key driver of business value.

In any business sale transaction tax implications are a critical consideration. One of the key factors in determining after-tax outcomes can often be the apportionment of sale price to individual assets.

In most cases the vendor wants to minimise the allocation to stock, depreciable assets and non-concessional CGT assets, while the purchaser wants the opposite.

It may be in both their interests that the consideration not be allocated on the contract, and instead allocated independently. From an Income Tax perspective, the allocations need not agree unless the assets are sold to a related party.

Each party should allocate a reasonable amount to each asset (ie. fair market values). Where the allocation is not reasonable, market value substitution rules and/or Part IV-A of the Tax Act may be applied to the transaction.

In some States, Stamp Duty applies to different components of the consideration at differing rates eg Victoria, where (as of this writing) Goodwill and intellectual property are not dutiable property. This may make it necessary for the parties to agree on apportionment of the sale price.

Practices vary from State to State. In Queensland, there is no price apportionment on most business sale contracts.

Purchasers and vendors should always consult their tax advisers before signing a contract.