Working capital adjustments are one of the most technically complex and emotionally charged elements of M&A transactions. They are also among the most common sources of post-closing disputes. Yet many founders enter a sale process with little understanding of how working capital mechanisms work or how significantly they can impact net proceeds.
The concept is straightforward in principle. When a buyer acquires a business, they expect to receive a normal level of working capital — the cash, receivables, inventory, and prepaid assets needed to run the business day-to-day, net of current operating liabilities like payables and accrued expenses. If the business is delivered with less working capital than normal, the purchase price is adjusted downward. If more, the price may be adjusted upward.
The challenge lies in defining normal. Buyer and seller often have different perspectives on what constitutes a normal or target level of working capital. Buyers typically want to set the target based on a trailing average — twelve months, twenty-four months, or some other period — that captures typical operating patterns. Sellers may prefer a methodology that results in a lower target, reducing the amount of working capital they need to leave in the business at close.
Seasonality adds complexity. Businesses with seasonal revenue patterns may have working capital that varies significantly throughout the year. The timing of the close relative to the business cycle can meaningfully impact the adjustment. This is why understanding your own working capital dynamics — and being able to articulate them clearly — is essential during negotiations.
The mechanics of the adjustment typically involve a two-step process. At closing, a preliminary estimate of working capital is used to calculate the initial purchase price. After closing — usually within sixty to ninety days — a final determination is made based on actual working capital at the close date. If the actual amount differs from the target, a true-up payment is made in the appropriate direction.
Several areas within working capital deserve particular attention. Accounts receivable quality — specifically, the collectibility and aging of outstanding invoices — can be a source of disagreement. Inventory valuation, especially for businesses with significant physical inventory, often requires careful analysis. Accrued liabilities and deferred revenue can also create complexity.
The best protection against working capital disputes is preparation. Understanding your own working capital patterns, maintaining clean and timely financial records, and working with advisors who can help negotiate appropriate definitions and mechanisms significantly reduces the risk of post-close surprises.
Founders should also be aware of potential manipulation. In some cases, buyers may attempt to define working capital in ways that effectively reduce the purchase price through the back door. Scrutinizing the specific items included and excluded from the working capital definition — and understanding the financial impact of each decision — is critical during the letter of intent and definitive agreement stages.
Working capital adjustments are technical, but they are not insurmountable. Founders who invest in understanding the mechanics, engage qualified advisors, and maintain disciplined financial practices are well-positioned to navigate this aspect of the deal with confidence.