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Working capital is a critical yet often misunderstood component of business sale transactions. It plays a central role in determining the true price a buyer will pay and a seller will ultimately receive. This article explores how working capital requirements affect business valuations and deal structures. We will examine how target working capital is calculated, why it is negotiated separately from enterprise value, how post-closing adjustments work, and the risk of deals falling through due to inadequate working capital. We will also review industry benchmarks and special considerations for seasonal businesses.

Introduction

In most private business sales, the agreed-upon purchase price is based on a cash-free, debt-free enterprise value, assuming a normalized level of working capital delivered at closing. However, the process of defining and agreeing to this normalized working capital target often presents challenges. Misalignment between buyer and seller expectations can result in last-minute disputes or significant post-closing adjustments. Understanding and negotiating working capital properly is essential not only for minimizing surprises but also for preserving the integrity of the agreed sale price.

Why This Topic Matters

Working capital (typically measured as current assets minus current liabilities) is the liquidity a business needs to function smoothly on a daily basis. From a buyer’s perspective, purchasing a business without sufficient working capital is akin to acquiring a machine without fuel. Conversely, sellers want to ensure they are not effectively funding the company’s operating cycle post-sale. Thus, working capital becomes a bridge between the buyer’s valuation and the seller’s realization of value.

Differing assumptions about required working capital can impact the net proceeds to the seller after closing. For businesses with seasonal cash flow patterns or fluctuating receivables and payables, working capital becomes even more significant and complex to negotiate. It is not uncommon for disputes to arise during or after closing if the working capital delivered is materially different from the agreed target.

Key Valuation Insights or Factors

How Target Working Capital is Calculated

A target working capital level is usually determined near the end of the due diligence process. It is commonly based on a historical average of net working capital levels over the past 12 months, or, in some cases, over a rolling 3 to 6-month period. The goal is to arrive at a consistent operating level that reflects the normal course of business, excluding any anomalous or non-recurring fluctuations.

For example, if a business fluctuates seasonally, both parties may choose to calculate the target using only comparable months from prior years to ensure seasonally appropriate benchmarks. It is also standard to exclude items such as excess cash, unusual prepaid expenses, or one-time payables or receivables that are not expected to recur post-closing.

Why It Is Negotiated Separately from Enterprise Value

Enterprise value is commonly derived using valuation methods such as EBITDA multiples or discounted cash flow (DCF) analysis. These methods assume continuity of operations and indirectly assume that the business will have enough working capital to support future revenue and EBITDA generation. However, they do not define explicitly how much working capital is to be delivered at closing. That is why the actual working capital target is carved out and negotiated separately.

In practical terms, if the actual working capital delivered at closing is greater than the agreed target, the seller may receive a positive adjustment to the purchase price. If it falls short, the purchase price may be reduced accordingly. These adjustments ensure neither party gains or loses due to temporary swings in the company’s operating liquidity.

Adjustment Mechanisms at Closing

Most purchase agreements include a mechanism for true-up adjustments following closing. This typically involves preparing a closing balance sheet within 30 to 90 days after the transaction date. Both parties agree on the calculation methodology during negotiation, including which accounts are included as working capital and any accounting conventions to be applied.

If the actual working capital calculated from the closing balance sheet exceeds the target, the buyer pays the seller the difference. If it is lower, the buyer is compensated accordingly. This mechanism protects both parties and reinforces the purpose of the working capital target as an economic stabilizer.

Disagreements often arise around accounting methods (cash vs accrual), classifications of specific liabilities, or cut-off dates for receivables and payables. For this reason, involving experienced accountants and valuation professionals throughout the process is crucial to avoid post-closing legal disputes or erosion of transaction value.

Real-World Applications

Industry Norms and Financial Ratios

Different industries have varying expectations for working capital needs as a percentage of revenue. For example, manufacturing and distribution businesses often carry significant inventories and receivables, requiring working capital levels of 10 percent to 20 percent of revenue. In contrast, software-as-a-service (SaaS) companies can operate with much lower working capital ratios, typically under 5 percent, due to prepaid billing and low receivables risk.

Buyers and sellers should look at industry comparables and financial statement trends when setting targets. Media and advertising firms, construction contractors, and real estate-related businesses also have unique revenue recognition patterns that cause significant fluctuation in working capital. Understanding these nuances is essential for setting fair and accurate targets.

Seasonal Businesses and Timing Considerations

Seasonal businesses pose a particular challenge in working capital negotiations. A business selling ski equipment may require high working capital levels in September but low levels in March. To mitigate unfair advantages, valuation professionals often use seasonal target ranges rather than a single number, or they apply trailing 12-month averages adjusted for seasonal cycles.

It is also common for buyers to require a minimum level of specific current assets (such as inventory) at closing if future revenue is seasonally front-loaded. In these cases, the purchase agreement may stipulate a floor or collar mechanism to prevent downside surprises.

Common Mistakes or Misconceptions

One of the most common misconceptions is that working capital is a fixed number. In reality, it fluctuates constantly and reflects the operational rhythm of the business. Relying on a year-end balance sheet, without considering cyclical variability, can result in a misleading target.

Another frequent mistake is ignoring the definitions within the purchase agreement. Sellers may assume that accounts like prepaid expenses or accrued liabilities will be excluded from the calculation, only to find that the buyer’s interpretation differs. This can create risk of post-closing disputes or adjustments that significantly affect proceeds.

Lastly, both parties sometimes underestimate the time and analysis required to finalize the post-closing adjustment. Without proper planning and accounting support, these reviews can become contentious and delay final settlement of funds or contingency releases.

Conclusion

Working capital adjustments are a core component of business sale transactions and can have a material impact on the realized price. Buyers and sellers need to approach working capital negotiation and modeling with the same level of diligence applied to enterprise valuation. Understanding how to calculate a proper target, accounting for seasonality, applying industry benchmarks, and clearly documenting terms in the purchase agreement all protect against post-sale surprises and disputes.

At our valuation firm, we support buyers, sellers, and intermediaries in modeling working capital requirements and structuring deals that reflect fair value. If you are planning to sell your company or preparing to make an acquisition, we invite you to contact us to learn your company’s value or discuss the specifics of your transaction.