My June column addressed many of the causes of poor agency valuations–and apparently struck a chord with readers. Most of the e-mails I received asked for more information regarding why working capital is so important to an agency's value. This month, I will explain why.

Think of an agency's value in terms of “what is being bought.” At a minimum, the buyer purchases the seller's customer files (or expirations). Depending on what is bought, other assets may include employees and company contracts. The value of every business purchased is the sum of its parts, and the more effectively the parts work together, the more valuable the business. Working capital plays an important role in this process.

Think of an agency as a machine. A key part of every machine is lubricating oil, a small component that plays a pivotal role in the effectiveness of the bigger parts. In the service industry, working capital is the lubricating oil that affects the big picture. Without adequate working capital, agencies don't run efficiently and can even break down, which may result in bankruptcy. An engine can run with inadequate oil, but with each revolution, it wears out a little.
The same holds true for an agency with inadequate working capital. It can run for a while, but each new sale compromises its longevity. Unfortunately for many agency owners, the wear and tear is so gradual it isn't recognized until it's too late, and the agency eventually “breaks down.”
Working capital is aptly named. It works 24 hours a day, seven days a week. It's not used for acquisitions or erecting buildings–that's investment capital. It's used to pay expenses and cover emergencies. Covering expenses comes first in a growing business, and working capital is used to pay those expenses. When an agency hires people for expansion, it has to pay them before they make their first sale, and that money comes from working capital. Without adequate working capital, the money has to come from somewhere–like the owner's paycheck.