When selling a business, many owners tend to focus on factors such as valuation, the deal structure, and their potential buyers. What typically gets less attention is working capital, yet it is one of the most frequent sources of post-close surprises.
Buyers expect a certain level of working capital to come with the business, and if the numbers fall short of expectations, the final price can drop. Getting this part of the deal right means understanding how adjustments work, what buyers are looking for, and how to prepare your business to meet that expectation.
The Role Of Working Capital In The Sale Process
Working capital provides the necessary liquidity for covering daily operational costs, such as payroll, inventory restocking, and vendor payments. For buyers, it acts as the operational cushion that keeps the business functioning smoothly on day one.
It’s computed by taking current assets, including accounts receivable and inventory, and deducting short-term liabilities such as accounts payable. When buyers assess a business, they expect it to come with enough “fuel in the tank” to maintain normal operations without injecting extra capital immediately after closing.
Because of this expectation, most purchase agreements include a working capital adjustment that modifies the final sale price. Rather than relying on a static valuation number, the final amount paid is “trued up” based on how the business’s actual working capital compares to a predetermined target, often called the “peg”.
If working capital at closing exceeds the peg, sellers may receive additional proceeds; if it falls short, the buyer gets a reduction.
How Adjustments Are Structured Through The Deal Timeline
The process of working capital adjustments plays out over several defined stages throughout the transaction, each carrying its own risks and opportunities for value preservation.
- Letter of Intent and Diligence: At the outset, both parties define what counts as working capital. Cash, debt, and non-operating liabilities are usually excluded. Any distinct carve-outs are discussed here to avoid confusion later.
- Quality of Earnings and Peg Development: Advisors analyze historical monthly balance sheets, typically over a six to twelve-month period, to calculate a normalized average. Seasonality plays a role, so rolling averages are often more reliable than point-in-time figures.
- Signing: The share purchase agreement should embed detailed definitions, including accounting policies and an illustrative schedule. It establishes a common basis for how the peg and working capital will be calculated.
- Closing: Sellers provide an estimated balance sheet, and the price is adjusted based on how that estimate compares to the peg.
- Post-Close True-Up: Typically occurring 60 to 90 days after closing, this step involves the buyer preparing a final working capital statement. Any discrepancy from the peg leads to a dollar-for-dollar adjustment in the final purchase price.
- Dispute Period: If disagreements arise, there is often a window for negotiation, followed by review from an independent accountant whose scope is limited to pre-agreed accounting methods.
Establishing a Reliable Peg
Getting the peg right is essential to avoid post-closing disputes; it should reflect normalized working capital under ordinary operating conditions. Sellers often make the mistake of using quarter-end figures, which can be misleading in seasonal industries. A rolling monthly average smooths out fluctuations and gives a more accurate picture.
Accounting consistency matters, meaning that the historical data used to set the peg should follow the same policies and conventions as the final closing statement. Differences between GAAP and non-GAAP practices often trigger disputes, especially when assumptions about revenue recognition, reserves, or accruals are not aligned.
The quality of inputs is another factor, so aging receivables, slow-moving inventory, and non-recurring accruals should be adjusted before finalizing the peg. Including outdated or inflated items increases the risk that the working capital figure will be challenged.
Some deals introduce collars around the peg, allowing for small fluctuations without triggering an adjustment. For example, a peg might include a 2% plus-or-minus band to reduce disputes over minor differences.
Deal Terms That Affect The Final Payout
The way a working capital adjustment impacts the final purchase price depends heavily on the structure and language of the agreement, with several common approaches seen across transactions:
- Dollar-for-Dollar Adjustments: Most US deals adjust the purchase price in full for every dollar above or below the peg.
- Scaled Adjustments: Some agreements soften the impact by applying a partial adjustment, such as 50 cents for every dollar over or under.
- Single vs. Two-Way Adjustments: A one-way adjustment only protects the buyer if working capital is low. A two-way structure adjusts in favor of whichever party is affected.
- Escrow or Set-Off: Buyers often recover downward adjustments from funds held in escrow, which are typically funded by the seller at closing.
- Dispute Clauses: The scope of any accounting arbitrator should be limited to applying the agreed-upon methods. Introducing new policies during a dispute can lead to unfair outcomes and extended litigation.
Alternatives To The Traditional Adjustment Model
Some sellers use a locked-box structure instead of a post-closing adjustment. While more common in European transactions, the locked-box model is gaining traction in U.S. middle-market and private equity deals. There is no true-up after closing.
Buyers accept the risk of working capital changes, provided there are protections like leakage covenants and warranties. While this approach offers more price certainty, it demands a higher level of trust and diligence upfront.
Protecting Deal Value
Working capital adjustments often sit in the background of M&A discussions, but they can have a real effect on the final price. Sellers who approach the peg with data, discipline, and aligned accounting practices are more likely to avoid any costly surprises.
If you’re thinking about a potential sale and want to avoid the post-close surprises that working capital disputes can trigger, connect with the experienced team at Roadmap Advisors.