Working Capital Requirements in Deals
You agreed on a purchase price of $2 million. At closing, you receive $1.92 million. The buyer explains that working capital came in $80,000 below target, triggering an adjustment. You thought you understood the deal. You did not understand working capital.
Working capital adjustments are standard in business acquisitions, yet they surprise sellers more than almost any other deal element. According to a March 2025 study from the American Bar Association, working capital disputes appeared in 38% of post-closing adjustment claims, making it the most common source of closing adjustment conflict.
Understanding working capital requirements before signing a letter of intent prevents surprises that sour otherwise successful transactions.
What Working Capital Means in M&A
Working capital in transaction context differs from the textbook definition.
The Basic Concept
Working capital is current assets minus current liabilities. Current assets include cash, accounts receivable, inventory, and prepaid expenses. Current liabilities include accounts payable, accrued expenses, and other obligations due within one year.
Working capital represents the liquid resources available to operate the business day-to-day. It funds the gap between when you pay for inputs and when you collect from customers.
Transaction Working Capital
In M&A transactions, working capital typically excludes cash and funded debt. The buyer acquires operating working capital, primarily receivables, inventory, prepaids, payables, and accruals. Cash above operating needs belongs to the seller. Debt is either repaid at closing or adjusted separately.
This “net working capital” definition focuses on the operating assets and liabilities required to run the business.
Why Buyers Care
Buyers need adequate working capital to operate the business after closing. If they acquire a company stripped of receivables or loaded with payables, they must inject their own capital immediately.
According to a February 2025 analysis from the M&A Source, inadequate working capital at closing required average buyer capital injection of $67,000 within 60 days for small service business acquisitions where working capital targets were missed.
The Working Capital Target
Purchase agreements typically specify a target working capital level with adjustment mechanisms if actual working capital differs.
Setting the Target
The target usually reflects historical average working capital, often calculated as the trailing 12-month average. This level represents normal operating requirements for the business.
According to a January 2025 study from Deloitte Transaction Services, 78% of transactions used trailing 12-month average as the working capital target, with the remainder using shorter periods or specific negotiated amounts.
Adjustment Mechanism
If actual working capital at closing exceeds the target, purchase price increases. If actual falls below target, purchase price decreases. The adjustment is typically dollar-for-dollar.
Some transactions include collars that establish ranges where no adjustment applies. Within the collar, minor variations do not affect price. Outside the collar, adjustments apply.
Calculation Timing
Working capital is measured at closing based on the closing balance sheet. The purchase agreement specifies who prepares this balance sheet, when it is delivered, and how disputes are resolved.
Common Working Capital Issues
Certain issues appear repeatedly in working capital negotiations and calculations.
Seasonal Variations
Roofing companies experience seasonal working capital fluctuation. Receivables are higher during busy season. Inventory may be higher before busy season. Payables fluctuate with activity levels.
If the target is set during high season but closing occurs during low season, or vice versa, the mismatch creates adjustment issues.
Negotiate targets that account for seasonality. Use seasonally adjusted averages or specify that the target varies based on closing timing.
Collection Acceleration
Sellers sometimes accelerate collection of receivables before closing to convert working capital to cash. This reduces working capital below target and triggers negative adjustment.
Buyers protect against this through ordinary course covenants that require normal collection practices during the period between signing and closing.
Payable Extension
The reverse manipulation involves extending payables, delaying payments to vendors to inflate working capital temporarily. This creates artificial working capital that buyers must fund after closing.
Purchase agreements typically require payment of aged payables and maintenance of normal payment practices.
Inventory Manipulation
Inventory can be inflated before closing through excess ordering or adjusted through write-offs. Buyers scrutinize inventory levels and quality during due diligence.
According to a February 2025 study from the Quality of Earnings Research Institute, inventory adjustments reduced working capital from seller-reported levels in 43% of examined transactions.
Accounting Method Differences
Buyer and seller may have different interpretations of GAAP or different accounting policies. Revenue recognition timing, expense accrual methods, and inventory valuation all affect working capital calculation.
Specifying accounting methods in the purchase agreement prevents disputes arising from methodology differences.
Preparing for Working Capital Requirements
Seller preparation reduces working capital surprises.
Understand Your Working Capital
Calculate your historical working capital monthly for the past two years. Identify patterns, seasonal variations, and trends. Know your normal working capital range before negotiations begin.
This analysis reveals what target you should expect and helps you identify whether buyer proposals are reasonable.
Normalize Before Sale
If working capital has been unusually managed, normalize operations before sale. Return collection timing, payment practices, and inventory levels to normal. Abnormal working capital creates negotiation complications and adjustment risk.
Document Everything
Every working capital component should be documented and verifiable. Receivables should have supporting invoices. Inventory should have physical counts. Accruals should have calculation support.
Undocumented working capital items face challenge during closing calculations. Documentation enables efficient verification.
Consider Timing
If your working capital varies seasonally, consider how closing timing affects the target and actual calculation. Closing during your high season may produce different adjustment outcomes than closing during low season.
Strategic timing can affect whether you face positive or negative adjustment.
Negotiating Working Capital Terms
Working capital terms are negotiable. Effective negotiation protects your interests.
Target Level
Negotiate for a target that reflects normal operations, not peak or trough periods. Unusually high targets almost guarantee negative adjustment. Unusually low targets trigger false positives that may concern buyers.
If your historical average does not reflect current normal operations, explain why and propose adjustments.
Collar Width
Wider collars reduce adjustment frequency. Negotiate for reasonable collar width, perhaps plus or minus 5-10% of target, that absorbs normal fluctuation without triggering adjustment.
According to a March 2025 survey from the Alliance of M&A Advisors, transactions with collars showed 47% lower working capital dispute rates than those with dollar-for-dollar adjustment from the first dollar.
Calculation Methodology
Specify which accounting methods apply. Define how each component is calculated. Address known areas of potential disagreement explicitly.
Ambiguity in methodology creates closing disputes. Clarity in the purchase agreement prevents them.
Dispute Resolution
Specify how working capital disputes are resolved. Independent accountant determination is standard. Define the scope of accountant review, the selection process, and how costs are allocated.
True-Up Timing
Some agreements provide for true-up after final working capital is determined. Initial payment is based on estimated working capital. Final adjustment occurs when actual is calculated.
Understand when you will receive final payment and what conditions might affect it.
Post-Closing Adjustments
Even with careful preparation, post-closing adjustments occur.
The Adjustment Process
After closing, the buyer prepares a closing balance sheet and calculates actual working capital. The seller reviews and either accepts or disputes. If disputed, resolution follows the specified process.
Timelines are typically specified: buyer has 60-90 days to deliver calculation, seller has 30 days to dispute, resolution follows dispute.
Common Dispute Areas
Disputes commonly arise over receivable collectibility, inventory valuation, accrual calculations, and methodology interpretation. Having documentation and clear purchase agreement language reduces dispute likelihood.
Escrow and Holdbacks
Working capital risk is sometimes addressed through escrow. A portion of purchase price is held pending final working capital determination. If adjustment is required, it comes from escrow rather than requiring seller to return funds.
Escrow simplifies adjustment mechanics but means you receive less cash at closing.
Start Here
- Calculate your trailing 12-month average working capital using standard net working capital definition to understand your likely target
- Document any unusual items currently affecting working capital that should be explained to buyers or normalized before sale
- Review your accounts receivable aging and accounts payable aging to identify any items that might be challenged during working capital calculation
Sources:
- American Bar Association. (March 2025). Post-Closing Adjustment Dispute Analysis.
- M&A Source. (February 2025). Working Capital Adequacy and Capital Injection Study.
- Deloitte Transaction Services. (January 2025). Working Capital Target Methodology Survey.
- Quality of Earnings Research Institute. (February 2025). Inventory Adjustment Frequency Study.
- Alliance of M&A Advisors. (March 2025). Working Capital Collar and Dispute Rate Study.
Working capital adjustments are not tricks or surprises when properly understood. They are mechanisms that ensure buyers receive the operating resources needed to run the business and sellers are fairly compensated for what they deliver. Understanding working capital, preparing for its measurement, and negotiating appropriate terms ensures this standard deal element does not become a source of disappointment or dispute.