Working Capital - The Surprise That Shrinks Your Check

You’ve negotiated what feels like a fair purchase price—let’s say $8 million for your distribution company. The LOI is signed, due diligence is progressing smoothly, and you’re already calculating your after-tax proceeds. Then your M&A attorney mentions something about “working capital adjustments,” and suddenly that $8 million could become $7.6 million at closing. Welcome to one of the most misunderstood and financially significant elements of selling a business.

Executive Summary

Working capital adjustments represent one of the most consequential yet frequently overlooked elements of M&A transactions, capable of shifting significant dollars between buyer and seller at closing and during post-closing true-up periods. While business owners focus intensely on headline purchase price negotiations, many fail to recognize that enterprise value doesn’t equal their actual check, a financial structuring reality that catches unprepared sellers when working capital mechanisms reduce proceeds below expectations.

While working capital adjustments serve legitimate business purposes (ensuring the buyer has adequate operating capital to run the business post-close), some buyers do employ tactics that artificially inflate requirements beyond actual operating needs. If the business requires $1.2 million in working capital and you’re providing only $900,000, the buyer must cover that $300,000 shortfall. Understanding this reframes working capital from “something done to you” to “a structural term to negotiate fairly,” while remaining alert to aggressive tactics.

This article examines how working capital targets are established, the mechanics of true-up calculations, and why the timing of your sale within your business cycle matters enormously. We explore common buyer tactics that inflate working capital requirements, the accounting nuances that create negotiation leverage, and specific strategies for managing working capital levels in the months leading up to a transaction. For business owners in the $2M-$20M revenue range (with enterprise values typically between $1M-$15M), based on our firm’s experience tracking working capital adjustments across 47 transactions over five years in this segment, these adjustments have typically ranged from 2-5% of enterprise value. This often represents $100,000 to $400,000 or more depending on business type and deal structure. This makes working capital arguably the most valuable deal term to understand beyond the headline purchase price.

Introduction

When we ask business owners what they expect to receive at closing, they almost universally cite their negotiated purchase price minus transaction costs. The concept of working capital adjustments rarely enters their mental calculation until it dramatically affects their actual proceeds.

Working capital, in its simplest form, represents the operating liquidity a business needs to function: current assets (primarily accounts receivable and inventory) minus current liabilities (primarily accounts payable and accrued expenses). Every business requires some level of working capital to operate, and buyers expect to receive a “normally functioning” business that includes adequate working capital to continue operations without immediate capital injection.

The challenge arises because buyers and sellers have fundamentally different perspectives on what constitutes “adequate” working capital. Sellers naturally want to extract maximum cash from the business before closing, collecting receivables aggressively, minimizing inventory, and stretching payables. Buyers want assurance they’re acquiring a business with sufficient liquidity to operate without disruption. This tension creates working capital negotiations that can move significant dollars between parties.

The mechanics seem straightforward on the surface: establish a “target” working capital level, measure actual working capital at closing, and adjust the purchase price up or down based on the difference. Here’s how that works in practice: If the buyer and seller agree the business needs $1.2 million in working capital to operate normally (the “target”), and at closing the actual working capital is only $900,000, the buyer reduces the purchase price by $300,000 to account for the shortfall. On an $8 million deal, that’s a material reduction in your after-tax proceeds.

What makes working capital particularly treacherous for sellers is its technical nature. While purchase price negotiations happen at the strategic level with principals engaged, working capital discussions often occur in the weeds between accountants, where sellers may not fully understand the implications of seemingly minor definitional decisions.

This article addresses working capital mechanics primarily in US-based M&A transactions under US GAAP accounting standards. International transactions and asset-sale structures may operate differently, consult local advisors for those situations.

Important caveat: Working capital optimization strategies are most effective for inventory-heavy businesses in competitive processes with multiple interested buyers. Service businesses or single-buyer scenarios may see limited benefit from aggressive optimization efforts. While some working capital terms are negotiable, others represent market standard practices that buyers typically won’t modify regardless of leverage.

How Working Capital Targets Get Established

The working capital target represents the “normal” level of working capital the business should have at closing. This target becomes the measuring stick against which actual closing working capital is compared, with the difference adjusting the purchase price dollar-for-dollar.

Most buyers propose using a trailing twelve-month average of working capital as the target. This seems reasonable, an average should smooth out seasonal variations and represent typical operating needs. But this methodology often favors buyers in ways sellers don’t immediately recognize.

Consider a business with significant seasonality. If the trailing twelve months includes your peak season when inventory and receivables naturally spike, that elevated period pulls up your “average,” meaning you need more working capital at closing to hit the target. If your working capital target includes peak seasons but you’re closing during slow season, you may face negative adjustment. The impact depends significantly on whether targets use averages, comparable periods, or other methodologies.

The Twelve-Month Average Trap

In a recent manufacturing company sale we advised, the trailing twelve-month average set the working capital target significantly higher than what was typical for the actual closing month, purely because the measurement period included atypical peak inventory levels from holiday preparation. This difference directly reduced the seller’s proceeds, not because anything was wrong with the business, but because the methodology favored the buyer.

Sophisticated buyers may also propose excluding certain current assets or including additional current liabilities in the working capital definition. Common examples include:

• Excluding cash and cash equivalents (standard, but the definition of “cash equivalents” matters)
• Including customer deposits or deferred revenue as liabilities
• Treating certain accrued expenses differently than the seller’s historical practice
• Adjusting for “normalized” receivables collections rather than actual

Each definitional nuance shifts value, and the cumulative effect of multiple small adjustments can be substantial.

Alternative Target-Setting Approaches

More seller-friendly approaches to establishing working capital targets include:

Median rather than average: Using the median of monthly working capital levels reduces the impact of outlier periods and often produces a lower target than averages skewed by peak seasons.

Closing-month historical analysis: If you’re closing in June, comparing to June working capital levels from prior years may be more appropriate than a trailing average that includes December peaks.

Minimum operating level: Some sellers successfully argue for a target based on the minimum working capital level at which the business successfully operated, rather than average levels that include optional excess.

Negotiated fixed target: In some transactions, both parties agree to a fixed working capital target number rather than a formula, providing certainty but requiring both parties to understand typical levels.

While deal competitiveness generally increases seller leverage on these points, other factors such as buyer sophistication, business complexity, and transaction timing also affect negotiation dynamics. In competitive processes with multiple buyers, push for definition discussions before targets. In single-buyer processes, you may have less flexibility and need to focus on negotiating the target number more aggressively while accepting buyer-proposed definitions.

The True-Up Mechanism and Post-Closing Adjustments

Working capital isn’t finally determined at closing. It’s estimated. The actual working capital calculation happens after closing, typically 60-120 days later for straightforward businesses, though complex businesses or disputed calculations may extend to 180 days or longer when a full accounting can be completed. This creates the “true-up” mechanism that can further adjust proceeds after you’ve already handed over the keys.

How True-Up Works

At closing, an estimated working capital figure is used to calculate the preliminary purchase price adjustment. If estimated working capital exceeds the target, you receive a higher payment at closing. If it falls short, your payment is reduced.

After closing, the buyer’s accountants prepare a detailed working capital calculation using final numbers. This calculation is then compared to the estimate used at closing, with the difference settled between the parties, either additional payment to the seller or a claw-back from proceeds held in escrow.

Here’s a worked example of how true-up operates:

In this example, the seller initially paid a $300,000 adjustment at closing but recovered $50,000 during true-up because actual working capital was higher than estimated. The net effect: a $250,000 reduction from the headline purchase price.

The true-up period is particularly dangerous for sellers because:

1. You’ve lost control of the books: Post-closing, the buyer controls accounting decisions that affect working capital calculations. Their incentive is to minimize the true-up payment (or maximize the claw-back).

2. Receivables collection changes: If the buyer’s collection practices differ from yours, accounts receivable values may change in ways that affect working capital calculations.

3. Accrual adjustments appear: Buyers often identify additional accrued liabilities or adjustments to receivable values during the true-up period.

4. You’re emotionally disengaged: After months of transaction stress, sellers often accept true-up calculations without adequate scrutiny, leaving money on the table.

Protecting Yourself in True-Up

Several provisions can protect sellers during the true-up process:

Detailed working capital definitions: The purchase agreement should specify exactly which accounts are included, how each is calculated, and what accounting principles apply. Ambiguity favors the party preparing the calculation. Post-closing, that’s the buyer.

Seller review rights: Ensure adequate time (typically 30-45 days, or as specified in the agreement) to review the buyer’s working capital calculation, with access to supporting documentation and the right to dispute items.

Dispute resolution mechanism: Specify how disputes are resolved, typically through a neutral accounting firm whose determination is binding. The cost-sharing arrangement for this arbitration matters. Some agreements split costs equally, while others assign costs to the party whose position was further from the final determination.

Caps on adjustments: Some sellers negotiate caps on negative working capital adjustments, limiting their downside exposure. This is more achievable in competitive processes where buyers are motivated to win the deal.

When Working Capital Matters Most and Least

Working capital dynamics vary significantly by business model, and understanding where your business falls on this spectrum helps you calibrate how much negotiation energy to invest.

High-Impact Business Types

For inventory-heavy businesses, working capital typically represents a significant percentage of revenue and constitutes a major component of transaction economics:

• Distribution companies: typically 12-18% of revenue in working capital
• Manufacturing operations: typically 15-25% of revenue
• Retail and wholesale: typically 20-30% of revenue

In these businesses, working capital adjustments frequently represent 3-5% of enterprise value and merit significant negotiation attention. The distribution company example that opens this article falls squarely in this category.

Moderate-Impact Business Types

Service businesses with meaningful accounts receivable but minimal inventory occupy a middle ground. Professional services firms, staffing companies, and B2B service providers typically see working capital at 8-15% of revenue. Adjustments here are often smaller in absolute terms but still material, potentially $75,000 to $250,000 for businesses in our target revenue range.

Lower-Impact Business Types

For capital-light businesses (software companies, consulting firms, subscription businesses with prepaid revenue), working capital may be a secondary negotiation concern. These businesses often have minimal inventory, faster receivables cycles, and deferred revenue that can actually work in sellers’ favor. Adjustments here tend to be smaller, though definitional issues around deferred revenue can still create material swings.

Strategic Buyer vs. Financial Buyer Differences

The type of buyer you’re negotiating with also affects working capital dynamics:

Strategic buyers (other operators in your industry) may care less about precise working capital mechanics if they can integrate operations quickly and have existing capital resources. They often have more flexibility on targets because they understand industry-specific working capital patterns.

Financial buyers (private equity firms and their portfolio companies) typically hold sellers to tighter working capital targets as part of their financial models. They’re more likely to employ aggressive true-up practices and push for buyer-favorable definitions. Their transaction professionals have seen hundreds of deals and know exactly which definitional items transfer value.

Common Buyer Tactics That Inflate Working Capital Requirements

Understanding buyer strategies allows sellers to recognize and counter moves that inflate working capital targets or reduce closing working capital calculations.

Expanding the Definition

Buyers may seek to include items in working capital that sellers don’t consider operating items:

Timing Games

Sophisticated buyers pay attention to transaction timing relative to the seller’s business cycle:

Slow-season closing: Proposing a close during the seller’s slow season when working capital naturally runs low, while using peak-inclusive averages as the target.

Month-end versus mid-month: Closing mid-month when payables have been paid but receivables haven’t been collected can artificially depress working capital.

Holiday period closings: Year-end closings may catch businesses with depleted inventory post-holiday or elevated payables from holiday inventory purchases.

The “Quality of Earnings” Discovery

During due diligence, buyer accountants prepare a “quality of earnings” report that commonly identifies potential adjustments to working capital calculations. In our experience advising sellers, QoE reports frequently surface at least one of the following findings:

• Receivables that are “stale” and should be reserved
• Inventory that is “slow-moving” and should be written down
• Accrued liabilities that are “understated”
• Prepaid expenses that don’t qualify for working capital inclusion

Each adjustment reduces closing working capital, benefiting the buyer. While some adjustments may be legitimate, sellers should scrutinize each with the same intensity applied to purchase price negotiations. Not every QoE finding reflects a genuine problem. Some represent buyer positioning for value transfer.

Strategies for Managing Working Capital Before and During the Transaction

Proactive working capital management in the months before and during your transaction can preserve significant value. But these strategies have operational costs and trade-offs that deserve careful consideration, and they’re most effective in competitive processes with multiple interested buyers.

Pre-Transaction Preparation

Understand your patterns: Before engaging with buyers, work with your accountant to analyze your own working capital levels over 24-36 months to understand your true operating requirements and seasonal variations. This typically requires 3-4 hours of internal time and may involve $3,000-$7,500 in advisory support depending on business complexity and historical data availability. Identify seasonal patterns, unusual periods, and the true minimum operating level. This analysis arms you for target-setting negotiations.

Clean up receivables appropriately: Write off receivables that are genuinely uncollectible. For legitimately aged receivables (customers who pay slowly but reliably), document your historical collection patterns so buyers understand these aren’t quality issues but rather industry norms. It’s better to collect truly stale receivables or write them off before the transaction than have buyers use them against you.

Right-size inventory thoughtfully: Excess inventory represents trapped cash that becomes the buyer’s property. Work inventory down to efficient operating levels before closing, but be cautious about aggressive pre-close reduction. If inventory depletion affects your ability to fulfill customer orders or maintain service levels during the transaction period, buyers will have leverage to demand higher working capital targets or renegotiate other terms. The goal is right-sizing, not artificial depletion.

Manage payables carefully: Careful management of payables timing can affect your working capital position. Sharp declines in payables may trigger buyer scrutiny about whether the reduction is sustainable. Work with your accountants to ensure payables management appears consistent with historical practice rather than appearing as pre-transaction manipulation.

Document your methodology: Establish clear, consistent accounting practices for working capital components. This provides a foundation to defend your practices during due diligence and true-up, though buyers may still propose different treatments that require negotiation.

During Negotiations

Negotiate definitions first: Before agreeing to a target number, nail down exactly what’s included in the working capital definition. The definition often matters more than the target.

Propose seller-friendly methodology: Don’t accept the buyer’s methodology as default. Propose alternatives that reflect your business reality (median rather than average, comparable-month analysis, or minimum operating levels).

Understand seasonality implications: If your business is seasonal, ensure the target and closing date align appropriately. A target based on peak-season averages combined with an off-season closing creates automatic negative adjustment. But timing alone doesn’t solve targets determined by trailing averages. Timing is one lever among many.

Build working capital considerations into price negotiations: If working capital adjustments are likely to reduce proceeds, factor that into your minimum acceptable purchase price. A $7.8 million price with neutral working capital may be better than $8 million with a $300,000 negative adjustment.

Near Closing

Monitor proactively: Work with your transaction accountants (not just attorneys) to prepare a detailed working capital estimate 1-2 weeks before closing using actual month-to-date data. Identify and resolve any discrepancies between this estimate and the target before closing. This preparation prevents surprises at true-up.

Manage the estimate carefully: The closing estimate affects your initial payment. Ensure the estimate is accurate and complete. Don’t leave money in escrow unnecessarily.

Collect strategically but carefully: Maintain normal collection practices and accelerate where possible without signaling distress or straining customer relationships. Collection acceleration should be subtle and consistent with your historical practices. Any sudden change in payment terms or collection intensity may signal transaction activity to customers and suppliers and can backfire if customers perceive it as a sign of distress.

Time discretionary payments: If you control closing timing, consider how discretionary payments (bonuses, inventory purchases, tax payments) affect closing working capital.

When These Strategies Can Backfire

No discussion of working capital optimization is complete without acknowledging failure modes. Working capital optimization carries several risks that deserve serious consideration:

Aggressive collection signaling distress: If customers perceive sudden collection intensity as a sign the business is struggling, that perception can damage relationships the buyer is counting on post-close. In one case, a seller’s pre-close collection push caused a major customer to request a meeting with the buyer to discuss “changes they were seeing,” creating leverage for the buyer to renegotiate terms.

Inventory reduction creating operational gaps: A manufacturing client reduced inventory to hit working capital targets but created stock-outs that delayed customer deliveries during the transition period. The buyer used these delays to argue for additional purchase price concessions beyond the working capital adjustment.

Payables acceleration revealing cash constraints: When a seller suddenly prioritized paying down payables, the buyer’s due diligence team questioned whether this reflected underlying cash flow stress. What was intended as working capital optimization became evidence supporting a lower valuation.

Customer relationship damage: Beyond signaling distress, aggressive collection can permanently damage relationships that represent significant post-close value to the buyer and that buyers are explicitly paying for in the purchase price.

Buyer suspicion of manipulation: When changes appear transaction-driven rather than business-driven, sophisticated buyers may question whether other aspects of the business have been similarly manipulated, potentially triggering deeper due diligence scrutiny or valuation adjustments.

The lesson: optimization should look like normal business operations, not transaction-driven manipulation. In single-buyer situations or deals with limited competitive tension, the risks of aggressive optimization often outweigh the benefits.

The Escrow Connection and Its Compounding Effect

Working capital adjustments don’t exist in isolation. They interact with other deal terms, particularly escrow arrangements, to compound their impact on seller proceeds.

Most transactions include an escrow holdback that secures the seller’s representations and indemnification obligations. Based on our transaction experience, escrow holdbacks typically range from 10-15% of purchase price, though this varies significantly by deal competitiveness, buyer type, and seller leverage. Industry data from escrow studies suggests the broader market range may extend to 15-20% for middle-market deals, with financial buyers typically pushing for higher holdbacks than strategic buyers.

Working capital true-up claims often come from this escrow, meaning negative adjustments are easily collected from funds already in the buyer’s practical control.

This creates an unfortunate dynamic: buyers face minimal friction in pursuing aggressive working capital positions because the money is already held by a neutral escrow agent. Sellers, by contrast, must fight to release their own funds.

The compounding effect works like this: On an $8 million transaction with $800,000 in escrow, a $300,000 negative working capital adjustment means the seller receives only $7.7 million at closing (purchase price minus escrow minus adjustment). If the true-up results in another $100,000 adjustment, that comes from the escrow, leaving only $400,000 to cover actual indemnification claims during the escrow period. The seller’s effective escrow (money at risk for indemnification) has been halved.

Alternative Approaches to Working Capital True-Ups

Understanding escrow interaction should inform both your working capital negotiation strategy and your escrow terms. Some alternatives worth considering:

Separate working capital adjustment account: Instead of using the indemnification escrow, hold a separate working capital adjustment reserve (typically 10-20% of the expected adjustment amount). This is released separately from indemnification claims, protecting working capital proceeds from unrelated indemnification disputes. This approach is more feasible in competitive deals where you have negotiation leverage.

Capped adjustment range: Negotiate a collar on working capital adjustments (for example, the buyer can claim adjustments only within a specified range, regardless of actual true-up calculation). This limits downside but requires meaningful leverage.

No post-close true-up: Some sellers negotiate to have the estimated working capital at close treated as final, with no true-up period. This creates certainty but requires an exceptionally carefully prepared closing estimate.

Alternative deal structures: Some transactions eliminate working capital adjustments entirely through asset purchases with specific asset/liability assumptions, or through “cash-free, debt-free” structures where working capital is normalized to zero. These structures shift complexity elsewhere in the deal but may be worth exploring depending on your situation.

Actionable Takeaways

Before Going to Market

1. Work with your accountant to analyze your working capital patterns over 24-36 months to understand your true operating requirements and seasonal variations. Budget $3,000-$7,500 for quality advisory support on this analysis. This foundational step prevents surprises during negotiations.

2. Write off genuinely uncollectible receivables and document collection patterns for legitimately aged accounts. These efforts improve both valuation and working capital position while providing defense during due diligence.

3. Document your accounting methodologies clearly. This provides a foundation to defend your practices, though buyers may still propose different treatments.

During Negotiations

4. Negotiate working capital definitions before discussing target amounts. The definition often matters more than the target itself.

5. Propose alternative target-setting methodologies (median, closing-month comparison, minimum operating level) that reflect your business reality rather than accepting buyer-proposed approaches automatically.

6. Model working capital adjustments into your minimum acceptable price, recognizing that headline price doesn’t equal your check.

7. Work with closing timing where possible to help manage working capital mismatches, while recognizing timing alone doesn’t solve targets determined by trailing averages.

At and After Closing

8. Prepare a detailed working capital estimate 1-2 weeks before closing using actual month-to-date data, working with transaction accountants to identify and resolve discrepancies.

9. Exercise your full review rights during the true-up period. Don’t accept buyer calculations without scrutiny simply because you’re relieved the deal closed.

10. Engage your own accountants throughout the process, not just your attorneys. Working capital is fundamentally an accounting issue requiring accounting expertise.

Conclusion

Working capital adjustments represent the gap between the purchase price you negotiate and the check you actually receive. For business owners in the $2M-$20M revenue range (particularly those in inventory-intensive industries), this gap frequently represents significant money that transfers between parties based on structural mechanisms rather than business value.

The complexity of working capital negotiations often means sellers defer to their advisors on these “details” while focusing personal attention on headline purchase price. This is precisely backward. While $100,000 in working capital improvement theoretically equals $100,000 in price improvement, the practical impact may differ due to escrow interactions, true-up risks, and timing of payment. Nevertheless, working capital negotiations typically receive a fraction of the attention they deserve.

Working capital adjustments are a normal part of M&A transactions, not a mistake to be eliminated. The goal is not to avoid adjustments entirely but to ensure they’re calculated fairly based on sound definitions and actual business requirements. Understanding these mechanics before entering negotiations (rather than discovering them during due diligence) provides the foundation for protecting your proceeds.

In competitive processes with strong negotiation leverage, working capital adjustments become a negotiation element you can significantly influence. In single-buyer processes, focus on ensuring definitions are fair and estimates are accurate. Either way, work with M&A advisors and transaction accountants who understand working capital dynamics and will advocate for seller-friendly structures rather than accepting buyer-proposed frameworks as standard.

The surprise that shrinks your check only surprises unprepared sellers. With proper understanding and realistic expectations, working capital adjustments become a structural term you negotiate deliberately rather than a value transfer you discover too late.