Working Capital Adjustments: The Hidden Deal Variable
Working capital adjustments are one of the most misunderstood — and financially significant — elements of M&A transactions. A poorly negotiated working capital peg can cost sellers hundreds of thousands at closing.
Definition
A working capital adjustment is a mechanism in M&A transactions that ensures the buyer receives the business with a 'normal' level of working capital (current assets minus current liabilities) at closing. The parties agree on a target working capital amount (the 'peg'), and the purchase price is adjusted up or down based on the actual working capital delivered at closing versus the target.
Why Working Capital Matters
Working capital is the cash a business needs to fund day-to-day operations — accounts receivable, inventory, prepaid expenses, minus accounts payable and accrued liabilities. When a buyer acquires a business, they expect to receive enough working capital to continue normal operations without injecting additional cash. Without a working capital adjustment mechanism, sellers could extract working capital before closing, leaving the buyer short.
How the Peg Is Calculated
The working capital peg is typically based on the trailing 12-month average of net working capital, though 6-month or 24-month averages are also used. Both parties negotiate which line items to include and exclude (e.g., cash, debt, tax liabilities are usually excluded). The calculation methodology should be clearly defined in the LOI and purchase agreement to avoid disputes.
The True-Up Process
At closing, estimated working capital is compared to the peg, with a preliminary adjustment to the purchase price. Within 60-90 days post-closing, a final working capital statement is prepared. If actual working capital exceeds the peg, the buyer pays the seller the difference. If it falls short, the seller reimburses the buyer. A collar (typically $25K-$100K) is sometimes used to avoid adjustments for minor variances.
Protecting Your Proceeds
Sellers should: negotiate a working capital peg based on a period that reflects normal operations (not seasonal peaks), clearly define included/excluded line items, understand the impact of timing on accounts receivable collections and payable payments near closing, and have their M&A advisor model various scenarios to anticipate the adjustment amount.
Common Questions
Frequently Asked Questions
What happens if working capital is below the target at closing?
If actual working capital at closing falls below the agreed-upon peg, the purchase price is reduced by the shortfall amount. This is why understanding and managing working capital in the months leading up to closing is critical.
Can working capital disputes kill a deal?
Working capital disagreements rarely kill deals outright but can cause significant closing delays and post-closing disputes. Clear definitions and calculation methodologies in the purchase agreement minimize this risk.
How much does the working capital adjustment typically affect the price?
For businesses in the $3M–$50M range, working capital adjustments typically range from $50K to $500K. The impact depends on the seasonality of the business, payment terms, and how well the seller manages working capital through closing.
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