Working Capital Adjustments in M&A: What Sellers Often Get Wrong
Working capital is rarely the headline number in a deal. It is rarely the reason a seller chooses one buyer over another. And yet, the working capital adjustment is one of the most common sources of post-closing disputes and value leakage in private company transactions.
Sellers often spend months negotiating purchase price and weeks negotiating working capital. The result is sometimes a deal in which several percentage points of value move at closing or shortly after, in ways the seller did not fully anticipate.
Why working capital matters in M&A
When a buyer acquires a business, they are typically acquiring it on a cash-free, debt-free basis with a "normal" level of working capital included.
The reasoning is straightforward. The business needs a certain amount of working capital, primarily receivables and inventory net of payables, to operate on a day-to-day basis. If the seller delivers significantly less working capital than usual, the buyer will need to inject capital. If the seller delivers more, the seller has effectively left value behind.
To address this, deals include a working capital adjustment mechanism in the purchase agreement.
The concept of delivered working capital
The mechanism works like this. The parties agree to a working capital target, often referred to as the peg. At closing, the actual working capital of the business is measured and compared to the peg.
If actual working capital exceeds the peg, the seller is paid the difference. If actual working capital falls short of the peg, the buyer is paid the difference (or the purchase price is reduced).
The intent is to make the buyer indifferent to the timing of inventory builds, receivable collection, and payable payment in the weeks before closing.
What is included in working capital
Working capital for transaction purposes usually includes:
• accounts receivable, net of allowances
• inventory, net of reserves
• prepaid expenses, where applicable
• accounts payable
• accrued liabilities and expenses
• deferred revenue, in some cases
Working capital typically excludes:
• cash and cash equivalents (taken by the seller in most structures)
• debt and debt-like items (paid out separately)
• income taxes payable (handled separately)
• intercompany balances
Whether deferred revenue and income tax items are included is frequently contested. The treatment can move the working capital target by hundreds of thousands of dollars even in lower mid-market deals.
How the working capital target is set
The peg is typically set based on the historical working capital of the business. Common approaches include:
• a trailing twelve months average
• a trailing three or six months average
• a normalized monthly average adjusted for seasonality
• a fixed dollar amount agreed by the parties
Each approach has strengths and weaknesses. A trailing twelve month average smooths short-term volatility. A trailing three month average captures recent conditions. A normalized approach accounts for seasonal businesses.
The choice of methodology is itself a negotiating point. It is not a technical question. It is a value question.
Where sellers get hurt
Common issues that produce value leakage on working capital include:
• agreeing to a peg without understanding the seasonality of the business
• failing to address how deferred revenue is treated
• failing to address how customer deposits are treated
• allowing the buyer to define "normal" using a period that was atypical
• weak documentation of inventory reserves and receivable allowances
• working capital growing in the months before closing without preparation
A seller who has not thought through these issues is often surprised at the working capital settlement.
Why the LOI should address working capital
Working capital should be addressed in the letter of intent, not deferred to the definitive agreement. The reason is simple: leverage. Once the LOI is signed and exclusivity begins, the seller has less ability to push back on working capital methodology.
A well-drafted LOI describes:
• the working capital target or the basis for setting it
• the methodology for calculating actual working capital at closing
• the timing of measurement and true-up
• the dispute resolution mechanism if the parties disagree
The closing date true-up process
In most deals, a preliminary working capital calculation is done at closing. A final, audited or reviewed calculation is done in the weeks after closing.
The true-up process typically involves:
• the buyer preparing a final closing balance sheet within a defined period (often 60 to 90 days)
• the seller having a period to review and dispute
• any disputed items going to a neutral accountant if not resolved
Sellers should ensure they have access to the underlying records and the right to engage their own advisors in the review.
Dispute resolution mechanics
When the parties cannot agree, the purchase agreement typically provides for a neutral accountant or arbitrator to decide.
Important considerations include:
• who selects the accountant
• what the accountant’s scope is (usually only disputed items)
• how costs are allocated
• whether the accountant’s decision is final and binding
In most deals, the accountant resolves only the specific items in dispute, not the whole calculation. This protects both sides from a full reopening but requires careful drafting.
Practical tips for sellers
Owners can protect themselves by:
• preparing a clear working capital analysis before going to market
• addressing working capital in the LOI, not in the SPA
• agreeing on methodology, not just on a dollar number
• documenting inventory reserves and receivable allowances consistently
• avoiding unusual working capital movements in the months before closing
• engaging accounting and financial advisors who understand transaction conventions
KitsWest Capital integrates working capital analysis into sell-side M&A advisory from the early stages of a process. Our work on this issue typically includes preparing a working capital baseline for negotiation, advising on the LOI language, coordinating with accounting advisors, and supporting the closing and post-closing true-up process.
On larger or more complex transactions, this work coordinates with a buy-side or sell-side Quality of Earnings provider, since working capital and EBITDA quality are closely related.
Working capital is one of the few places in private company M&A where a few percentage points of value can move at the very end of the process, often after the seller has emotionally committed to the deal. That is precisely why it deserves attention earlier, not later.
For owners considering a sale, working capital is not a back-office accounting issue. It is part of the price.
If you are evaluating a business sale, acquisition, unsolicited offer, or valuation matter, KitsWest Capital welcomes confidential discussions.
A worked closing adjustment
Assume the purchase agreement sets a $1.20 million working capital target. At closing, the seller delivers $1.08 million after applying the agreement’s definitions. The purchase price is reduced by $120,000. If the seller had looked only at the accounting balance sheet and expected $1.31 million, the apparent $230,000 gap would not be a buyer tactic. It would be a definition problem discovered too late.
The bridge could be straightforward: $1.31 million of book working capital, less $90,000 of receivables older than the permitted age, less $70,000 of obsolete inventory, less $45,000 of accrued bonuses omitted from current liabilities, and less $25,000 of customer deposits treated as debt-like. The defined amount is $1.08 million. Every line should be traceable to the closing statement and to wording negotiated before signing.
Now assume the target was based on a twelve-month average that included a seasonal peak. If a normal closing month would require only $1.05 million, the seller has effectively transferred an extra $150,000 of operating capital to the buyer. That is why the target methodology can matter more than the final true-up calculation.
Definitions decide the economics
The agreement should identify every included account, excluded account, accounting policy, consistency rule, aging convention, reserve, and cutoff procedure. A generic phrase such as current assets less current liabilities is not precise enough. Cash, debt, taxes, transaction expenses, deferred revenue, customer deposits, accrued bonuses, lease liabilities, and shareholder balances often require explicit treatment.
Consistency is also critical. A buyer should not calculate the target using one policy and closing working capital using a stricter policy. If inventory reserves were historically booked only at year-end, the agreement must state how the closing reserve will be measured. If receivables are excluded after ninety days, the parties should agree whether subsequent collections cure that exclusion.
Frequently asked questions
Is working capital added to the purchase price?
Usually the negotiated enterprise value assumes a normal level is delivered. The adjustment changes the price only when closing working capital is above or below the agreed target.
How many months should be used for the target?
There is no automatic answer. Twelve months can smooth seasonality, but a growing, declining, or recently changed business may require a trend-adjusted period. The selected window should reflect the capital required to operate the business after closing.
Should deferred revenue be included?
It depends on the remaining cost to perform, the purchase price framework, and the agreement’s definitions. Treating the full balance as a liability can overstate the economic burden when much of the related work is already complete.
What happens if the parties disagree after closing?
The purchase agreement should prescribe notice, supporting schedules, review rights, a negotiation period, and referral of accounting disputes to an independent accountant. Legal interpretation disputes may follow a different path.
Can the working capital target be negotiated at the LOI stage?
Yes, and it should be. The letter of intent may not contain the final schedule, but it should state the intended methodology and flag unusual accounts before the headline price becomes psychologically fixed.
Next steps
Build a monthly working capital schedule before going to market. Reconcile it to the financial statements, isolate seasonality and growth, test every non-standard account, and model the purchase price result under several possible definitions. This work belongs beside normalized EBITDA, not at the end of diligence.
KitsWest supports owners through business sale negotiations, purchase price mechanics, and closing analysis. Contact us before signing an LOI if the target, exclusions, or true-up process are still described in general language.
