In most acquisitions of privately held companies, working capital is one of the most often misunderstood deal points. While buyers and sellers tend to focus on earnings and headline purchase price, the mechanics of net working capital can increase or decrease what ultimately changes hands at closing. Understanding how working capital is defined, negotiated, and adjusted is essential to a smooth transaction and avoiding surprises.
At its core, net working capital represents the short-term operating liquidity required to run the business. In an M&A context, it is typically defined as accounts receivable plus inventory and certain other current assets (those that will convert to cash or provide value post-transaction), less accounts payable and other current liabilities. Importantly, most transactions are structured on a “cash-free, debt-free” basis, meaning that cash and interest-bearing debt, such as bank loans and capital lease obligations, are excluded from the transaction. (Note that “working capital” and “net working capital” are used interchangeably in this article and in transactions.)
Working capital is often described as the “gasoline” that keeps a business running day to day. Buyers expect to receive a company with a “full tank of gas,” not one that requires an immediate cash infusion after closing. That expectation is what drives the working capital adjustment mechanism seen in most deals.
The Working Capital Target
A key negotiation point in any transaction is the working capital target. This target represents the normalized amount of working capital the buyer expects the business to be delivered with at closing. Typically, the target is based on the average net working capital over a trailing period, often the previous 6 or 12 months.
At closing (or shortly thereafter, once final numbers are confirmed), actual net working capital is compared to the agreed-upon target:
- If actual working capital exceeds the target, the purchase price is increased dollar-for-dollar.
- If actual working capital is below the target, the purchase price is reduced dollar-for-dollar.
In effect, working capital becomes a true-up mechanism designed to ensure the buyer receives a business ready to continue operations.
Key Considerations in Setting the Target
Arriving at the “right” working capital target is not always straightforward. Several factors can influence what constitutes a reasonable level:
1. Growth or Decline Trends
If a company is growing rapidly, it may require increasing levels of receivables and inventory to support that growth. In this case, a simple historical average may understate future needs, which a buyer may use to try to negotiate a higher net working capital target. When we represent companies in transactions, we take the position that funding future growth is the responsibility of the buyer, not the seller, and we push back on providing a higher level of net working capital at closing. Conversely, a declining business may require less working capital after closing.
2. Seasonality
For businesses with seasonal sales cycles, timing matters. A trailing average that includes peak and trough periods may need to be adjusted to reflect expected working capital at the anticipated closing date based on where the closing falls in the seasonality ups and downs.
3. Unusual or Non-Recurring Events
Extraordinary transactions can skew historical working capital levels. For example, a large project with extended payment terms might inflate accounts receivable during a specific period. A skilled advisor will identify these anomalies and argue for normalization so the target reflects typical operations.
4. Related-Party Balances
Receivables or payables involving related parties are usually excluded, as they may not reflect arm’s-length, ongoing business practices.
These nuances are often heavily negotiated and can materially impact deal economics. Similar to other negotiated elements (like contingent payments discussed in our prior article, “Earnouts: A Useful Tool to Bridge the Value Gap”), the details matter.
Operational Habits That Affect Value
One area that frequently gets overlooked is how day-to-day cash management practices influence working capital levels. For instance, some companies routinely pay vendor invoices ahead of their due dates. While this may feel relationship-friendly, it can artificially increase historical working capital.
Here’s why: when payables are reduced faster than necessary, less liability is carried on the balance sheet. That raises net working capital above what is truly required to operate the business. As a result, sellers may be on the hook to deliver a higher working capital amount at closing, effectively leaving money on the table. Similarly, if accounts receivable collection practices are lax, average accounts receivable may be higher than they should be, again causing historical net working capital to be higher than it should be.
Business owners should evaluate these practices well in advance of a sale. Ensuring that payment terms are followed consistently can help present a more accurate and often more favorable working capital profile.
Related Article: Value Building: What to Focus on at Different Stages Before a Sale
Why It Matters
Working capital adjustments are not just technical accounting entries; they directly affect sale proceeds. A misunderstanding of how working capital is defined or calculated can lead to disputes, delays, or unexpected price reductions late in the transaction process.
For sellers, the goal is to deliver a normalized, supportable level of working capital that reflects how the business operates. For buyers, it’s about ensuring continuity and avoiding the need to inject additional capital immediately after closing. Getting this right typically requires thoughtful analysis, clear financial records, and experienced guidance.
Final Thoughts
While it may not grab headlines like valuation multiples or strategic synergies, working capital is a critical component of nearly every M&A transaction. It serves as a bridge between historical performance and future operations, and ensuring alignment on this issue can make the difference between a smooth closing and a contentious one.
If you’re preparing for a sale or want to better understand how working capital may impact your transaction, we’d be happy to help. Contact Us to start the conversation.