Business owners spend months negotiating a sale price, and then learn after closing that their actual proceeds were 5–10% lower than expected. In most cases, the culprit is a working capital adjustment that wasn't fully understood until the deal was done.
Working capital adjustments are one of the most frequently misunderstood parts of any M&A transaction. This guide explains exactly what they are, how they work, why they matter, and what you can do to protect your outcome during negotiations.
What Is Working Capital in an M&A Deal?
Working capital, in its simplest form, is the difference between a company's current assets and current liabilities. It represents the short-term financial resources the business needs to operate on a day-to-day basis. Common components include:
- Current assets: accounts receivable, inventory, prepaid expenses, and cash
- Current liabilities: accounts payable, accrued expenses, and short-term obligations
In most middle market M&A transactions, the buyer assumes ownership of the business's working capital. The underlying principle is that the business should be delivered with enough working capital to operate normally, not stripped of its operational financial resources before the sale.
What Is a Working Capital Adjustment?
A working capital adjustment is a mechanism that adjusts the final purchase price up or down based on the actual working capital at closing versus an agreed-upon target, called the working capital peg or target peg.
Here's how it works: before signing the purchase agreement, both parties negotiate a target working capital level. This target is usually based on a trailing 12-month average, adjusted for seasonality. If actual working capital at closing exceeds the target, the purchase price goes up by the difference. If actual working capital falls short of the target, the purchase price goes down.
A Simple Example
Imagine your business sells for $15 million with a working capital target of $2 million. If your actual working capital at closing is $2.3 million, you receive an additional $300,000. If it comes in at $1.7 million, your net proceeds are reduced by $300,000. The adjustments are typically calculated and finalized in a post-closing true-up process, 60–90 days after the transaction closes.
Why Working Capital Adjustments Surprise Business Owners
The main reason working capital adjustments create surprises is that sellers focus on the headline purchase price without fully understanding the mechanics of the adjustment. A $15 million deal can easily settle at $14.2 million if working capital falls short, not because anything went wrong operationally, but because the target was set incorrectly or the calculation methodology wasn't fully negotiated.
Common sources of working capital disputes include:
- Disagreement on which line items are included in the working capital calculation
- Inventory valuation methodology, cost vs. net realizable value
- Timing of accounts receivable collections around the closing date
- Deferred revenue and whether it's treated as a liability or excluded
- Accrued liabilities that are contested between buyer and seller
How the Working Capital Peg Is Set
The working capital peg is negotiated as part of the purchase agreement. Buyers typically propose a target equal to the trailing 12-month average monthly working capital. Sellers sometimes push back on this figure, especially if the business is seasonal, growing, or has had unusual cash timing in the prior year.
Getting the peg right is critically important. A peg that is too high means you'll almost certainly owe money back at closing. A peg that is too low means the buyer gets a windfall. Experienced M&A advisors and attorneys spend considerable time negotiating the peg and the calculation methodology before the purchase agreement is signed.
The Post-Closing True-Up Process
How It Works
After closing, the buyer prepares a closing balance sheet and calculates actual working capital using the methodology agreed in the purchase agreement. The seller reviews this calculation and can dispute specific line items within a defined window, typically 30–60 days. If the parties can't agree, a neutral accountant named in the purchase agreement resolves the disagreement. The party that owes money under the final calculation typically pays from an escrow account established at closing.
Escrow Holdbacks
Most purchase agreements include an escrow holdback, typically 5–15% of the purchase price, that is held for 12–18 months post-closing. The working capital true-up is one of several mechanisms that can draw from this escrow. Sellers should understand that their actual net proceeds at closing are the purchase price minus the escrow holdback, minus any working capital shortfall determined in the true-up.
How to Protect Yourself as a Seller
Engage Early and Model Multiple Scenarios
Before entering any LOI negotiation, work with your M&A advisor and accountant to model what your working capital looks like under various scenarios. Understand the trailing 12-month average, identify seasonal fluctuations, and flag any unusual items that could affect the calculation.
Negotiate the Definition and Methodology
The working capital definition in the purchase agreement is everything. Push for specificity: which exact accounts are included, how inventory is valued, how deferred revenue is treated. Ambiguity benefits whoever has more lawyers and more accounting resources, usually the buyer.
Manage Working Capital Leading Up to Close
In the weeks before closing, avoid actions that artificially deflate working capital, like delaying receivables collections or accelerating payable payments. These create a lower-than-normal working capital reading and can trigger a purchase price reduction. Conversely, unusual buildups of inventory or receivables can create a peg dispute if the buyer argues they don't reflect normal operations.
Conclusion
Working capital adjustments are a normal part of every M&A transaction, but they shouldn't be a surprise. Business owners who understand the mechanics before signing an LOI are in a far better position to protect their proceeds and avoid costly post-closing disputes.
At First Turn Capital , our advisory process includes a thorough working capital analysis before we enter any negotiation. We help business owners understand their exposure, set realistic expectations, and negotiate terms that protect the value we've worked hard to create throughout the sale process.
Frequently Asked Questions
Is working capital adjustment common in all M&A deals? Yes. Virtually all middle market M&A transactions include a working capital adjustment mechanism. It is a standard feature of purchase agreements, not an unusual request from buyers.
What happens if I disagree with the buyer's post-closing working capital calculation? You have the right to review and dispute the calculation within a defined period, typically 30–60 days after receiving the buyer's closing statement. If the parties cannot resolve the dispute, it goes to an independent accountant or dispute resolution firm named in the purchase agreement.
Can working capital adjustments reduce my sale price significantly? Yes. On large transactions, working capital shortfalls can result in seven-figure purchase price reductions. This is why thorough pre-close preparation and careful negotiation of the working capital definition is essential.
What is the difference between working capital and cash in an M&A deal? In most deals, cash is excluded from the working capital calculation and is treated as a separate item, usually either retained by the seller or specifically addressed in the purchase agreement. This is sometimes called a "cash-free, debt-free" basis for the transaction.
How far in advance should I analyze my working capital before a sale? At least 12 months before going to market, if possible. This gives you a clear picture of seasonal patterns, identifies any unusual items, and allows time to address issues that could result in a working capital shortfall at closing.
