The Role of Working Capital in M&A Transactions

Working capital is a fundamental component of mergers and acquisitions (M&A) transactions, influencing deal valuation, purchase price adjustments, and post-closing operations. Buyers and sellers must align on how working capital is defined, measured, and transferred to ensure a fair and smooth transaction. Misunderstandings around working capital can lead to post-closing disputes and unexpected financial impacts, making it essential for both parties to have a clear strategy when structuring a deal.

One of the most commonly misunderstood aspects of M&A transactions is that working capital is typically included in the sale. Many sellers assume they are selling only the hard assets and goodwill of their business, but working capital is an integral part of what makes the business function daily. Just as a car is expected to come with gas in the tank when sold, a business must be transferred with enough working capital to sustain normal operations.

To ensure fairness, M&A transactions use a working capital adjustment, which prevents either party from gaining a financial advantage based on fluctuations in working capital levels. If the seller delivers more working capital than expected, they are compensated for the excess. If less is provided, the purchase price is reduced accordingly. This adjustment ensures that neither the buyer nor the seller benefits unfairly from short-term changes in working capital leading up to the sale.

What Is Working Capital and Why Does It Matter?

Working capital represents the short-term liquidity available to a business, ensuring it can fund daily operations without disruption. It is generally calculated as current assets minus current liabilities, but in M&A, the focus is on non-cash, debt-free working capital. This means that the calculation typically includes accounts receivable, inventory, and prepaid expenses on the asset side, while excluding cash balances. On the liability side, it includes accounts payable and accrued expenses but excludes debt obligations.

Buyers and sellers view working capital from different perspectives. Buyers see it as an assurance that the business will have enough liquidity to sustain operations immediately after closing without requiring an immediate infusion of capital. A company that is handed over with inadequate working capital could require additional cash to cover short-term expenses, which is not an ideal situation for any acquirer. Sellers, on the other hand, need to ensure that the agreed-upon working capital level is fair and reflects the normal operating needs of the business rather than an artificially high target that lowers their overall deal proceeds.

Working Capital Targets in M&A Deals

To ensure a seamless transition, buyers and sellers agree on a working capital target, which represents the expected level of non-cash, debt-free working capital at closing. This target is typically determined by analyzing historical working capital levels over a defined period, often the trailing twelve months, to establish a fair and normalized benchmark.

Determining an appropriate working capital target requires careful consideration of various factors. Seasonal fluctuations play a significant role, especially for businesses with cyclical revenue patterns. If working capital naturally peaks and declines over the course of a year, setting a target based solely on recent months could unfairly benefit one party. Similarly, industry norms and operational characteristics influence what a reasonable working capital level should be. Businesses that require large amounts of inventory or have longer payment cycles with customers may need higher working capital targets compared to those with more rapid turnover.

Additionally, working capital targets are not just about balance sheet figures—they reflect the functional needs of the business. Setting the right target ensures that the buyer receives a business that is fully operational from day one, while the seller avoids unnecessary post-closing price reductions due to unrealistic expectations set in the agreement.

Working Capital Adjustments and Their Impact on Purchase Price

Since working capital levels fluctuate, most M&A agreements include a working capital adjustment mechanism to ensure that the buyer receives the business with an adequate level of liquidity. This adjustment compares the actual working capital at closing to the agreed-upon target. If the actual working capital is higher than the target, the seller may receive an increase in the purchase price. Conversely, if the actual working capital is lower than the target, the buyer may be entitled to a price reduction to offset the shortfall.

A useful analogy for understanding the fairness of working capital adjustments is a home sale that includes a fuel oil tank. If the agreement assumes the tank is half full, but on closing day the seller has left it nearly empty, the buyer would have to spend additional money to bring it back to the expected level. Conversely, if the seller leaves a full tank, they should be compensated for the extra value provided. The same principle applies to working capital in an M&A transaction—it is not an additional asset being sold but rather a necessary component for the business to operate as expected. The working capital adjustment ensures that both parties get exactly what was agreed upon at closing.

These adjustments prevent manipulation in the period leading up to closing. Sellers who attempt to aggressively collect receivables while delaying payments to suppliers may create a short-term boost in working capital that does not reflect normal operations. Buyers protect themselves against such tactics by reviewing trends in working capital and setting mechanisms for fair adjustments. Conversely, sellers must ensure that the buyer does not impose an unreasonable working capital target that would force them to leave excessive value in the business at closing.

Post-closing disputes related to working capital are common, particularly when accounting methodologies differ between buyer and seller. Questions often arise over which assets and liabilities should be included in the calculation. Issues such as whether certain accrued expenses or prepaid items should be included can lead to disagreements that, if not properly defined in the purchase agreement, may escalate into legal disputes. Clear, well-documented agreements on how working capital is calculated, along with transparent financial reporting, help mitigate these risks.

Conclusion

Working capital plays a central role in M&A transactions, directly impacting both deal valuation and post-closing financial stability. Buyers seek to ensure that the acquired business has adequate liquidity to continue operations, while sellers aim to optimize their deal proceeds by managing working capital effectively. Since M&A deals typically exclude cash and debt from working capital calculations, focusing on non-cash, debt-free working capital is key to structuring a fair and efficient transaction.

Establishing an appropriate working capital target, structuring clear adjustment mechanisms, and proactively managing financial records can prevent costly disputes and ensure a seamless transition. The more well-prepared sellers are regarding their working capital trends, the better positioned they will be in negotiations. Similarly, buyers who conduct thorough due diligence and ensure alignment on working capital terms can avoid unexpected financial burdens after closing.

Engaging experienced M&A advisors and financial professionals throughout the process ensures that working capital negotiations are handled effectively, protecting both parties from unexpected financial impacts. A well-structured working capital agreement leads to smoother deal execution and a more predictable financial outcome for all involved.