What Is Working Capital in a Business Sale?
In the context of a business acquisition, net working capital (NWC) is typically defined as current assets (excluding cash) minus current liabilities (excluding short-term debt). It represents the operational liquidity a business needs to function day-to-day without requiring immediate cash infusions from the new owner.
When a buyer purchases a business, they expect it to be delivered as a "going concern." This means the business must have enough inventory to fulfill orders, enough accounts receivable to generate near-term cash, and a normal level of accounts payable to keep vendors satisfied. Working capital ensures the business doesn't stall the moment the keys change hands.
Why Do Working Capital Adjustments Happen?
Working capital fluctuates constantly. Inventory is sold and replenished, invoices are sent and paid, and bills come due. Because of this continuous cycle, the exact amount of working capital on the day you sign the Letter of Intent (LOI) will almost certainly be different from the amount present on the day of closing.
To account for this, buyers and sellers agree on a "Target Working Capital" (often called a peg) during negotiations. This target represents the historical, normalized average of working capital required to run the business. At closing, an adjustment is made based on the actual working capital delivered compared to this target.
If the actual working capital is higher than the target, the purchase price is increased, and the buyer pays the seller the difference. If the actual working capital is lower than the target, the purchase price is decreased, and the seller receives less cash at closing.
How Target Working Capital is Calculated
Determining the target working capital is often one of the most heavily negotiated points in a transaction. Buyers want a high target to ensure they have plenty of cushion, while sellers want a low target to maximize their cash at closing.
The most common method for calculating the target is the 12-month trailing average (TTM). This approach smooths out seasonality and provides a fair representation of the business's typical needs. However, adjustments must often be made for:
- Seasonality: If your business has extreme peaks and valleys, a simple average might not reflect the specific capital needs at the exact time of closing.
- Growth: If the business is growing rapidly, historical averages might underestimate the working capital needed to support current operations.
- One-time events: Unusual inventory build-ups or delayed payables should be normalized out of the calculation.
The Closing Surprise Sellers Miss
Many sellers focus entirely on the headline purchase price and overlook the working capital mechanism until the closing statement is prepared. This can lead to a rude awakening.
For example, imagine a seller agrees to a $5 million purchase price with a target working capital of $500,000. In the months leading up to closing, the seller stops buying inventory and aggressively collects receivables to stockpile cash (which they keep in an asset sale). At closing, the actual working capital delivered is only $200,000. Because this is $300,000 below the target, the purchase price is adjusted downward, and the seller only receives $4.7 million. The seller feels blindsided, even though the math is perfectly sound.
The Post-Closing True-Up
Because it is impossible to know the exact working capital on the day of closing (invoices are still arriving, and inventory counts take time), transactions typically use an estimated working capital figure at closing.
Within 60 to 90 days after closing, the buyer will prepare a final working capital statement based on actual closing day figures. This leads to a "true-up" payment. If the final number is higher than the estimate, the buyer pays the seller. If it's lower, the seller pays the buyer (often out of an escrow holdback). Negotiating the specific definitions of current assets and liabilities before closing is critical to avoiding disputes during the true-up process.
How to Prepare and Protect Your Value
To avoid working capital surprises and protect your proceeds, you must actively manage this process from the beginning:
- Define it early: Ensure the LOI clearly defines how working capital will be calculated and what specific accounts are included.
- Run business as usual: Do not change your inventory purchasing or payable habits just because you are selling. Operate normally.
- Clean up the balance sheet: Write off bad debt and obsolete inventory long before going to market so they don't skew the target calculation.
- Work with experts: An experienced M&A advisor and transaction attorney will ensure the working capital mechanism is fair and properly structured.
Conclusion
Working capital adjustments are a standard and necessary part of lower middle market business sales. While they can seem complex, understanding how they work allows you to negotiate a fair target, operate your business correctly through the transition, and avoid painful surprises at the closing table. Proper preparation and expert guidance are your best defenses against leaving money behind.
