“I thought we agreed on $20 million. Where did the other $500,000 go?”
I’ve lost count of how many times a business owner has asked some version of that question at closing. They aren’t upset because the purchase agreement has changed. Rather, they are surprised because they didn’t fully understand one of the most important concepts in a mergers and acquisitions transaction: working capital.
Most business owners spend months negotiating valuation and purchase price. Far fewer spend time understanding how working capital works. Yet it can have a significant impact on the amount they ultimately receive at closing.
Working capital is one of the most misunderstood concepts in mergers and acquisitions and one of the most heavily negotiated. The negotiations often focus not only on the amount of adjustment, but also on which assets and liabilities should be included in the calculation and what historical period should be used to establish a fair target (or “peg”). Ironically, it often becomes a point of frustration because neither the buyer nor the seller believes they are trying to gain an unfair advantage.
In reality, working capital is usually a “no one wins” negotiation. Its purpose is simply to ensure that both parties receive the economic deal they believed they negotiated.
What Is Working Capital?
In its simplest form, working capital represents the short-term assets needed to operate the business, less the short-term operating liabilities. These short-term assets generally include accounts receivable, inventory, and prepaid expenses, while operating current liabilities typically include accounts payable and accrued expenses. Cash and debt are typically excluded because they are addressed separately in the purchase agreement.
The goal with respect to working capital is straightforward. The buyer expects the business to have enough operating assets to continue running normally after closing.
Why Does Working Capital Matter?
Imagine you agree to buy a manufacturing company. You would expect to receive customer receivables, inventory to fill orders, and enough operating assets to keep production moving. Assume that instead, immediately before closing, the seller collects every receivable, delays purchasing inventory, and pays almost none of the outstanding bills.
While the business technically transfers to you, it immediately needs cash just to function. From the buyer’s perspective, that is not the business they agreed to purchase.
Now let’s flip the situation.
Suppose the seller accelerates inventory purchases, pays every vendor early, and leaves unusually high receivable balances outstanding. In this case, the buyer receives extra working capital without having to pay anything extra for it. From the seller’s perspective, they gave away value for free.
Neither outcome is fair.
The Target Working Capital
Once the parties agree on how working capital will be defined and how the peg will be calculated, the actual working capital at closing is compared to that target.
If actual working capital exceeds the target, the purchase price generally increases. If it falls below the target, the purchase price is generally reduced.
The adjustment is not intended to reward or penalize either party. Rather, it is designed to ensure that the buyer receives the level of operating working capital reflected in the negotiated purchase price and that the seller is compensated fairly for delivering more or less than that amount.
Why Everyone Hates Working Capital
Working capital adjustments often create tension because they occur late in the transaction. By that point, everyone is emotionally invested in getting the deal across the finish line. The seller views the negotiated purchase price as “their number”; the buyer views the working capital adjustment as ensuring they receive the business they agreed to buy. Neither side feels like they are asking for something unreasonable, yet every dollar of adjustment affects someone’s proceeds. That is why working capital discussions can become surprisingly emotional.
A Simple Example
Assume a business is sold for $20 million. The agreed target working capital is $2 million.
The business has only $1.5 million in working capital at closing. The purchase price is reduced by $500,000.
Many sellers feel they “lost” half a million dollars but in reality, the buyer paid less because they received half a million dollars less in operating assets.
Had the business been delivered with $2.5 million of working capital, the purchase price would generally increase by the same amount. The adjustment works both ways.
The Insight Most Sellers Miss
The biggest mistake I see isn’t that sellers misunderstand the calculation. It’s that they assume the purchase price in the letter of intent is the amount they’ll receive at closing. The truth is that it rarely is.
Working capital is just one of several purchase price adjustments that determine a seller’s ultimate net proceeds. The definition of working capital is often more important than the calculation itself, as is the method of accounting used to compute it (e.g., GAAP vs. historical practice). Should deferred revenue be included? What about customer deposits? Are accrued bonuses operating liabilities? How are unusual or seasonal fluctuations handled?
These questions can materially change the final purchase price. I’ve seen transactions where the disagreement wasn’t over the valuation of the business. It was over how specific balance sheet accounts should be classified.
Start the Conversation Early
Working capital should never be an afterthought. The earlier the parties understand the calculation, the fewer surprises there will be at closing. Historical balance sheets should be analyzed well before the purchase agreement is finalized, and both parties should clearly understand the definition of working capital, the methodology used to calculate the peg, and any proposed exclusions or adjustments.
Working capital is not simply an accounting exercise. It directly affects the amount sellers take home after the transaction closes.
Final Thoughts
Working capital may never be the most exciting topic in an acquisition, and it certainly won’t generate headlines. Generally, no one celebrates a working capital adjustment, but understanding it can prevent disputes, preserve value, and avoid unpleasant surprises.
The purchase price is only one piece of the equation, and the ultimate net proceeds depend on much more than the number in the letter of intent. Sometimes the biggest difference between a good deal and a great deal isn’t the valuation. It’s understanding the details behind the numbers.
If you’re considering selling your business, don’t wait until the purchase agreement is drafted to understand working capital. By then, your negotiating leverage may be limited. Spend time early with your tax advisor, accountant, and legal team to understand how working capital will be defined, how the target will be calculated, and how it could affect your ultimate net proceeds. A little planning before the deal begins can prevent costly surprises after it closes.
If you’re considering selling your business or evaluating an acquisition, the WG M&A team can help you understand how working capital may affect your transaction and your ultimate proceeds.
