How Much Working Capital Does a New Business Owner Need
Buying a business is a major step, and new owners are usually very optimistic when they take over operations. You have found your ideal business, you are confident that you can run it successfully, you have done your due diligence, and now you are figuring out how much money you need to come up with to complete the purchase.
During all this excitement, there is one very important factor that some new owners overlook or do not spend enough time thinking about: working capital. How much working capital do you need when you take over the business? What is the best way to determine the appropriate amount?
The first thing that needs to be said is that running out of working capital is a major disaster for any new business owner. This could put you in a big financial hole right off the bat, and it is a setback that could take a long time to recover from. In in the worst cases, it could even force you to close or sell your business.
How to Plan for Working Capital in Your New Business: Working capital is the amount of available funds you will need to operate from the time you take over the business until the time when the business is self-sufficient (i.e., you have enough cashflow to cover expenses a draw a livable income).
How much working capital you will need depends largely on the type of business you are purchasing and other specific factors. For example, if you are taking over a business where customers pay immediately (such as a restaurant or retail store), then you will have cash flow from Day One and you will not need as much working capital. If, on the other hand, you are getting into a business where clients pay for services 30 or 60 days out or longer, then you will need enough liquid capital on hand to plan accordingly.
Seasonality is another factor that should be considered when you are evaluating how much working capital you will need. Some businesses have busy seasons and slow seasons, as is the case with CPA practices that are typically busiest during the first part of the year, and resorts that are often busier during the summer travel season.
Here are some additional factors that new business owners may need to consider when determining the appropriate amount of working capital to have on hand:
- Inventory: If you are getting into a business that sells physical products to customers, you will need to consider the cost of inventory. You will want enough capital to keep an adequate amount of inventory on hand for customers who want to buy it. And estimating future inventory needs will often be based largely on previous sales.
- Revenue and Expense Forecasts: While we cannot predict the future with 100% certainty, previous profit and loss statements can give you a pretty good idea of what you can expect for revenues and expenses going forward. When looking at past figures, be ultra-conservative with your revenue projections and assume that there will be a drop in sales when you take over. In addition, assume that your fixed expenses will increase by 10-20 percent. This will should provide you with a nice cushion to work with.
- Cost of Desired Upgrades: When you evaluate the business you are purchasing, you may be thinking that the business could benefit by making some technological upgrades and other improvements to help it run more efficiently and profitably. Be sure to include cost estimates for all the essential one-time upgrades you plan to make.
- Costs for Additional Marketing: In addition to upgrades/improvements, you might want to invest in some advertising/marketing campaigns that could jumpstart your sales. You might even be considering hiring some extra salespeople. These costs should also be factored into your working capital calculation.
- Available Capital from Current Owner: Ask if the seller is including any liquid capital along with the business that they are turning over to you. This might even be something that could be negotiated into the purchase.
Generally, you should try to enter your new business with at least three months of available working capital. As we talked about earlier, the last thing you want is to get into a cash crunch, so always err on the side of caution when you make your calculations.
Consult with a Local Business Intermediary: When you are considering purchasing a new business, it is wise to work with a local business intermediary/broker. Experienced business brokers thoroughly understand the ins and outs of transactions like these, and they have worked with numerous buyers who have been in your shoes. Consult a local business broker to discuss issues like having adequate working capital and other challenges that buyers face, so you can ensure that you are well prepared to be successful in your new venture.