Business owners often focus on the price stated in a letter of intent. That figure is important, but it does not necessarily equal the amount ultimately received. Cash, debt, transaction expenses, escrows, financing terms, and working capital can all affect the bridge from enterprise value to seller proceeds.
Because the working capital target can materially influence that bridge, owners should understand the company’s historical position before accepting the economic terms of an offer.
Why Working Capital Matters in a Sale
Many acquisitions are negotiated on a cash-free, debt-free basis. Under this structure, cash and funded debt are accounted for separately from enterprise value. Depending on the agreement, cash may be distributed before closing or added to the consideration, while debt generally reduces the amount payable to the seller.
The buyer also expects to receive a company that can continue operating in the ordinary course.
Consider a distributor that relies on inventory to fill orders, receivables that will convert into cash, and customary payment terms from suppliers. If the seller collects an unusual amount of receivables, reduces purchases, or delays vendor payments before closing, the company may transfer with less operating capital than it has historically carried.
The buyer may then need to contribute cash shortly after the acquisition to restore normal operations.
In transactions that use a closing-accounts mechanism, the parties typically establish a working capital target, often called the peg. The company’s closing balance is compared with that benchmark. A shortfall may reduce the consideration, while an excess may increase it, depending on the purchase agreement.
The mechanism does not ordinarily reopen the negotiated enterprise value. Instead, it adjusts the consideration to reflect the operating assets and liabilities delivered at closing.
Other transaction structures, such as a locked-box arrangement, may address working capital differently and may not involve a conventional post-closing true-up.
What Counts as Working Capital?
In accounting, working capital is commonly described as current assets minus current liabilities. In an acquisition, the definition is narrower and negotiated.
The calculation may include trade receivables, inventory, certain prepaid expenses, accounts payable, accrued payroll, and other operating liabilities. Cash, funded debt, income taxes, seller transaction expenses, shareholder loans, and related-party balances are often excluded or addressed elsewhere in the purchase-price formula.
The structure of the transaction also matters. In a stock sale, the buyer generally acquires the company with its existing balance-sheet accounts, subject to negotiated adjustments. In an asset purchase, the parties determine which receivables, inventory, prepayments, payables, and accruals will transfer.
A balance classified as working capital in one deal may be treated as debt, a retained liability, or a separate deduction in another. The transaction documents should align the definition with the assets acquired and obligations assumed.
How the Target Is Established
Historical monthly balances, often covering at least one full operating cycle, commonly provide the starting point for the peg. The selected period and methodology, however, depend on the business and the transaction.
The analysis may need to account for seasonality, recent growth, changes in customer or supplier terms, new facilities, product launches, acquisitions, discontinued operations, or unusual balances.
Suppose a manufacturer builds inventory ahead of its busiest quarter. Its annual average includes both high and low points in the production cycle. If the transaction closes shortly before peak demand, the company may ordinarily carry more inventory and receivables than the average suggests.
The benchmark should reflect the company’s normalized working capital requirements, taking its operating cycle and anticipated closing date into account. Historical results remain important, but they may need to be adjusted for identifiable changes that the buyer and seller agree are relevant.
The same account definitions, classifications, reserve policies, and accounting methods should then be applied when calculating the closing balance. Changing the methodology after the target has been established can distort the comparison and shift value between the parties.
From Enterprise Value to Seller Proceeds
Assume a company is valued at $25 million. At closing, it has $500,000 of cash, $3 million of funded debt, $400,000 of seller transaction expenses, and a $400,000 working capital shortfall. The estimated calculation would be:
| Purchase-price bridge | Amount |
|---|---|
| Enterprise value | $25,000,000 |
| Plus: cash included in the closing calculation | $500,000 |
| Less: funded debt | ($3,000,000) |
| Less: seller transaction expenses | ($400,000) |
| Less: working capital shortfall | ($400,000) |
| Estimated consideration before other closing items | $21,700,000 |
The company is still valued at $25 million. The amount payable is lower because enterprise value and seller proceeds are different measures. Other terms may further affect the final result, including escrows, holdbacks, rollover equity, seller notes, earnouts, and taxes.
Many mechanisms provide dollar-for-dollar adjustments in both directions. Others may be one-way or include thresholds, collars, caps, or escrow arrangements. Owners should understand how the provision treats both an excess and a shortfall.
Where Negotiations Commonly Arise
The formula is usually straightforward. The more difficult questions concern how the underlying accounts are measured and classified.
Receivables: Are the recorded balances likely to be collected, and are reserves calculated consistently? Overdue invoices, customer disputes, credits, claim denials, and historical collection patterns may affect the amount included. The closing statement should use the reserve methodology specified in the agreement and applied when the peg was established.
Inventory: Is the stock usable and properly valued under the agreed framework? Manufacturing and distribution companies may face questions involving obsolete, excess, damaged, or slow-moving items. Unless the parties expressly agree otherwise, the closing calculation is generally not intended to become a new fair-value assessment based on the buyer’s post-acquisition plans.
Accrued liabilities: Have obligations relating to the pre-closing period been fully recorded? Bonuses, commissions, payroll taxes, vacation, freight, rebates, and vendor invoices may be incurred before completion but paid afterward. Omitting those amounts can overstate the working capital delivered.
Classification: Is an item being treated as working capital, debt, a transaction expense, or another deduction, and is it being counted more than once? Customer deposits, deferred revenue, related-party balances, unpaid taxes, and committed capital expenditures may require specific treatment. The same economic exposure generally should not reduce consideration more than once, whether through working capital, debt, transaction expenses, or indemnification, unless the agreement expressly provides otherwise.
Working capital can be negative.
Some businesses collect customer payments before paying suppliers or completing the related work. Subscription companies, prepaid service businesses, and companies that receive deposits may therefore operate with negative net working capital. A negative peg is not necessarily a sign of weakness. The relevant question is whether the closing balance is above or below the agreed benchmark.
How the True-Up Is Completed
The amount used at closing is often an estimate because the company’s books cannot always be finalized on the transaction date.
Because the books cannot always be finalized on the transaction date, the initial adjustment is usually based on an estimate. The agreement specifies who prepares that estimate and the post-closing calculation, as well as the seller’s review and objection rights.
The contractual closing statement should also be distinguished from the buyer’s purchase accounting. Unless permitted by the purchase agreement, fair-value adjustments or new reserve assumptions recorded for the buyer’s financial reporting should not be introduced into the closing calculation.
The Industry Shapes the Analysis
The accounts that matter most depend on the company’s operating model.
Manufacturers and distributors tend to focus on inventory, receivables, freight, rebates, and supplier accruals. Construction companies may place greater weight on work in process, billing positions, retainage, and estimated costs to complete. Healthcare providers often examine payer mix, claim status, denials, and contractual allowances.
Staffing firms may carry little inventory but still require substantial operating capital because payroll is funded before customers pay. Subscription businesses frequently negotiate the treatment of deferred revenue, customer prepayments, and implementation obligations.
The methodology should follow the economics of the company rather than a generic template.
What Owners Should Do
Owners and their advisors should analyze historical working capital before signing a letter of intent. The LOI may not establish the final peg or detailed definition, but it should avoid assumptions that could materially alter the economics of the offer.
Before the purchase agreement is signed, the parties should resolve the target, included accounts, accounting policies, and true-up procedures.
A practical review should include:
- Monthly balance-sheet trends over a full operating cycle
- Receivable aging, inventory, payables, and major accruals
- Seasonal patterns and recent operational changes
- Debt-like, nonoperating, and related-party balances
- Consistency between the proposed peg and historical accounting practices
- The bridge from enterprise value to expected proceeds
Operational decisions made before closing should also be considered in light of the adjustment.
Accelerating collections, reducing purchases, or delaying vendor payments may increase cash temporarily. If those actions lower the working capital delivered by the same amount, the benefit may be offset through the closing calculation.
Look Beyond the Headline Price
The practical lesson is straightforward: an offer should be evaluated based on the proceeds it is expected to produce, not enterprise value alone.
That requires understanding the company’s operating cycle, testing the proposed peg against historical balances, and resolving how key balance-sheet accounts will be treated before the transaction documents are finalized.
When those issues are addressed early, the mechanism can operate as intended: a fair reconciliation of the operating assets and liabilities delivered with the business, rather than a source of avoidable disagreement after the headline price has been negotiated.
