Working capital adjustments catch most Arizona business sellers completely off guard, often reducing their expected proceeds by $50,000 to $300,000 or more at closing.
I’ve watched this scenario play out hundreds of times over 25 years. A seller agrees to a purchase price, celebrates the deal, then gets blindsided when the final closing statement shows significant reductions they never anticipated.
The working capital adjustment mechanism exists in nearly every middle-market business sale. Yet most sellers don’t understand it until days before closing when it’s too late to negotiate better terms.
Understanding working capital in business sales before you receive offers allows you to negotiate terms that protect your interests and avoid unpleasant surprises at the closing table.
Key Takeaways:
- Working capital adjustments reconcile the difference between target working capital and actual working capital delivered at closing
- Most purchase agreements include working capital pegs requiring sellers to deliver minimum levels of current assets minus current liabilities
- The working capital true-up process typically occurs 60-90 days after closing when final numbers get calculated
- Normalized working capital calculations determine the target baseline buyers expect you to deliver
- Poor working capital negotiation can cost sellers six figures in unexpected reductions to sale proceeds
What Is Working Capital Adjustment in Business Sales
Working capital represents the funds available for daily business operations. The basic calculation takes current assets minus current liabilities. Enterprise value ignores the businesses financing structure therefore cash & interest bearing debt are excluded; the Buyer has to pay for cash left in the business and the seller has to pay for debt left in the business.
Current assets exclude cash, and include accounts receivable, inventory, and prepaid expenses. Current liabilities usually include accounts payable, accrued expenses, and sometimes short-term debt. There are many other necessary adjustments to properly calculate the net working capital (NWC) target including for “debt like” balances.
Why Buyers Care About Working Capital
Buyers need sufficient working capital to operate your business after they take over. If you strip out all the cash, collect all the receivables, and pay down payables right before closing, you’re leaving the buyer with an undercapitalized business.
They can’t operate without adequate inventory. They need receivables to convert to cash. They require normal payable balances reflecting standard payment terms with vendors.
The working capital adjustment ensures you deliver a business with enough operating capital for the buyer to run it successfully from day one.
The Basic Mechanism
Purchase agreements establish a working capital target or peg. This represents the normal level of working capital your business maintains during ordinary operations.
At closing, the parties estimate working capital based on the most recent financial statements. The buyer pays the purchase price based on this estimate.
Post-closing, typically within 60-90 days, both sides calculate the actual working capital delivered. If actual working capital exceeds the target, the buyer owes you money. If it falls short, you owe the buyer.
This working capital true-up process settles the difference between what was promised and what was actually delivered.
How Working Capital Affects Sale Price
The working capital peg doesn’t reduce your purchase price if you deliver what you’re supposed to deliver. But it absolutely reduces your proceeds if you fall short.
Let me show you how this works with real numbers.
Your purchase price is $5 million. The working capital target gets set at $400,000 based on normalized levels over the past 12-24 months.
At closing, the estimated working capital shows $380,000. You’re already $20,000 short, but everyone agrees to true it up after closing with final numbers.
Ninety days later, the final working capital calculation comes back at $350,000. You delivered $50,000 less than the target.
You now owe the buyer $50,000. This comes out of escrowed funds or requires you to write a check.
Your $5 million sale just became $4.95 million because of the working capital deficiency.
Common Causes of Working Capital Shortfalls
Sellers often inadvertently reduce working capital in the months leading up to closing.
You might collect receivables more aggressively than normal, reducing accounts receivable below typical levels. You might reduce inventory as sales slow during the transition period. You might delay paying vendors, but those unpaid invoices get reflected in the final settlement.
Some sellers intentionally try to maximize cash at closing without realizing they’re creating working capital deficiencies that will cost them later.
Understanding Net Working Capital Calculation
The net working capital calculation typically excludes certain items that create confusion for sellers.
Interest-bearing debt gets excluded. Credit lines, term loans, and other financed debt don’t factor into working capital calculations since the purchase agreement addresses debt separately.
What Gets Included
Accounts receivable represent money customers owe for delivered goods or services. This gets included in working capital at its collectible value.
Buyers sometimes negotiate quality adjustments reducing receivables for aged invoices unlikely to collect. A receivable 120 days past due might get discounted 50% in the working capital calculation.
Inventory gets included at its current value, normally valued at cost. Buyers want inventory at normal operating levels so they can fulfill orders and maintain sales.
But inventory valuation creates disputes. Obsolete inventory, damaged goods, or slow-moving items might get valued at less than your books show.
Prepaid expenses like insurance, rent, or deposits that benefit the buyer get included as assets.
Accounts payable represent money you owe vendors. This gets included as a liability reducing net working capital.
Accrued expenses like wages, taxes, utilities, and other obligations usually get included as liabilities.
The Devil in the Details
Working capital definitions vary significantly between transactions. Your purchase agreement might include or exclude specific items based on negotiation.
Some agreements exclude certain inventory categories. Others adjust for seasonal fluctuations. Many include specific provisions for how to value aged receivables or slow-moving inventory.
The specific definition matters enormously because it determines what you must deliver and how it gets calculated.
The Working Capital Peg and Target Setting
Setting the working capital target represents a critical negotiation point that most sellers don’t pay enough attention to.
Buyers typically propose using average working capital over the trailing twelve to twenty four months. This sounds reasonable until you realize seasonal businesses have significant fluctuations.
If you’re selling in December but your business carries extra inventory and receivables in summer, the twelve-month average might exceed what exists at closing by $200,000 or more.
You’d owe the buyer $200,000 for a working capital deficiency that’s completely normal given the seasonal timing.
Negotiating the Target
Push for working capital targets that reflect the actual time of year when closing occurs.
For seasonal businesses, use the average working capital for the specific month of closing over the past three years. This gives a realistic target matching normal operations at that time.
For businesses with significant growth, historical averages might not reflect current working capital needs. You might need higher targets to account for the larger scale of operations.
Some sellers negotiate working capital collars or bands. The agreement might specify that adjustments only occur if working capital varies by more than 10% from target. Small fluctuations get ignored.
These negotiations require your teams involvement to model different scenarios and understand the implications.
The Working Capital True-Up Process
After closing, the working capital true-up process determines the final settlement.
The buyer’s accountants prepare a closing balance sheet calculating actual working capital delivered. This calculation follows the definitions in the purchase agreement.
You have the right to review their calculation and dispute items you believe are incorrect. Most agreements provide 30 days to review and respond.
If you dispute the calculation, the agreement typically requires negotiation between the parties’ teams. If they can’t resolve disputes, an independent accounting firm makes the final determination.
Working Capital Escrow
Most purchase agreements escrow funds specifically for working capital settlements.
The escrow might hold $100,000 to $500,000 depending on transaction size and expected working capital. This money gets held until the true-up completes.
If you delivered more working capital than required, you get the difference plus the escrowed amount. If you fell short, the buyer takes what you owe from escrow and you get the remainder.
The escrow protects both parties during the settlement process.
Special Considerations for Arizona Sellers
Arizona’s diverse business landscape creates specific working capital challenges.
Construction and contracting businesses often have significant work-in-progress and retention receivables. These items require special handling in working capital calculations since they might not convert to cash for months.
Distribution businesses carry substantial inventory that can fluctuate significantly. Inventory valuation becomes critical, especially for seasonal products or goods with limited shelf life.
Manufacturing operations might have raw materials, work-in-progress, and finished goods inventory across multiple locations. Accurately valuing and counting this inventory at closing requires careful planning.
Service businesses generally have lower working capital requirements but might have deferred revenue or prepaid customer deposits that affect calculations.
Understanding your industry’s specific working capital characteristics helps you negotiate appropriate terms.
Common Working Capital Mistakes
I’ve watched sellers make predictable errors that cost them money.
Ignoring Working Capital Until Due Diligence
Most sellers don’t think about working capital adjustments until buyers raise it during due diligence. By then, you’ve lost negotiating leverage.
Understand your normal working capital levels before going to market. Have your team calculate it using different methodologies so you know what buyers might propose.
Accepting Buyer’s First Proposal
Buyers often propose working capital targets and definitions that favor them. Their initial proposal might include aggressive adjustments for aged receivables or exclude favorable inventory categories.
Everything in the working capital section of the purchase agreement is negotiable. Push back on unfavorable terms.
Mismanaging Working Capital Pre-Closing
Some sellers think collecting receivables and reducing inventory before closing puts more money in their pocket. But if it creates working capital deficiencies, you’ll owe it back.
Operate the business normally in the months leading to closing. Don’t make dramatic changes to working capital components.
Not Reviewing the True-Up Calculation
After closing, some sellers don’t carefully review the buyer’s working capital calculation. They assume it’s correct and accept the settlement.
Your team should review every line item in the closing balance sheet. Buyers make mistakes or interpret definitions favorably to themselves. Catching errors can save you tens of thousands.
FAQ
What is working capital adjustment and how does it affect my sale price?
A working capital adjustment reconciles the difference between the target working capital specified in your purchase agreement and the actual working capital you deliver at closing. If you deliver less than the target, you owe the buyer the difference, reducing your proceeds. If you deliver more, the buyer owes you. The adjustment typically gets settled 60-90 days after closing once accountants calculate the final numbers.
How is net working capital calculation determined in business sales?
Net working capital equals current assets minus current liabilities, though the specific definition varies by transaction. Current assets typically include accounts receivable, inventory, and prepaid expenses. Current liabilities include accounts payable and accrued expenses. Cash and interest-bearing debt usually get excluded. Your purchase agreement specifies exactly which items to include and how to value them.
What happens during the working capital true-up process after closing?
The buyer’s accountants prepare a closing balance sheet showing actual working capital delivered, typically within 60 days of closing. You have 30 days to review and dispute their calculation. If disputes arise, the parties’ accountants negotiate to resolve them. An independent accounting firm makes final determinations if they can’t agree. The settlement gets paid from escrowed funds or through direct payment between parties.
How does working capital negotiation impact my final proceeds?
Working capital negotiation affects your proceeds in two ways. First, the target level determines how much working capital you must deliver. Higher targets mean you deliver more assets or the buyer pays you less at closing. Second, the definitions determine what gets included and how items get valued.
What is a working capital peg and why does it matter?
A working capital peg (target) is the target level of working capital specified in your purchase agreement that you must deliver at closing. It typically equals the average working capital over a defined period, often the trailing twelve months. The peg matters because you owe the buyer for any shortfall below this level. Setting the peg appropriately for your business type, seasonality, and timing of closing can save you significant money in post-closing adjustments.
Protecting Your Interests in Working Capital Negotiations
Working capital adjustments represent one of the most misunderstood aspects of business sales, yet they significantly affect your final proceeds.
Sellers who understand working capital in business sales before receiving offers negotiate better terms and avoid costly surprises. Those who ignore it until closing often lose substantial amounts they never expected.
Start by having your team calculate your working capital using different methodologies. Understand what’s normal for your business and how it fluctuates seasonally or with growth.
When you receive offers, pay close attention to working capital provisions. Don’t just focus on purchase price. The working capital terms might matter more to your final proceeds than another $100,000 in headline price.
Negotiate definitions that fairly reflect your business operations. Push back on unfavorable valuation methods for receivables or inventory. Consider collars that ignore small fluctuations.
Manage your business normally in the months before closing. Don’t try to maximize cash by creating working capital deficiencies you’ll have to repay.
After closing, review the buyer’s working capital calculation carefully with your team. Challenge errors or unfavorable interpretations.
The sellers who walk away with maximum proceeds understand that business sales involve dozens of terms beyond purchase price that affect what they actually take home. Working capital adjustments rank near the top of that list.
Ready to sell your business and want guidance on negotiating favorable working capital terms that protect your proceeds?
Schedule a confidential market review to discuss your situation and learn how proper working capital negotiation can save you six figures in your transaction.
