Working Capital Considerations When Planning for a Future Transaction

Working capital plays a central role in purchase price negotiations. Proper planning and management of working capital prior to a sale can significantly increase the amount of cash a seller receives at closing. Yet many owners underestimate how the working capital provisions in a purchase agreement affect their final proceeds—sometimes leaving substantial money on the table.

Understanding how working capital is defined, measured, and negotiated during a transaction allows sellers to prepare well in advance and approach negotiations from a position of strength.

Understanding Net Working Capital in a Transaction

In most acquisitions, buyers and sellers agree on a Net Working Capital (NWC) target—sometimes called a working capital peg. This target represents the amount of working capital the buyer expects the business to deliver at closing in order to operate normally after the transaction.

Net working capital typically consists of current operating assets and liabilities.

Current Assets

Typically include:

• Inventory (at cost or fair market value)
• Net realizable accounts receivable
• Prepaid assets (in some cases)

Typically exclude:

• Cash, unless tied to customer deposits
• Seller-related assets such as related-party notes receivable

Current Liabilities

Typically include:

• Accounts payable
• Accrued expenses
• Customer deposits

Typically exclude:

• Lines of credit
• Interest-bearing debt
• Seller-related liabilities such as distributions payable

While the components may appear straightforward, how they are defined in the purchase agreement can materially impact the economics of a deal.

How the NWC Target Is Determined

The NWC target is typically based on a historical average of the company’s working capital over a specified period—often 6, 12, 18, or 24 months.

Changing the timeframe used to calculate this average can meaningfully alter the working capital target. In many transactions, the purchase price is negotiated before the working capital peg is finalized. When that happens, the working capital target effectively determines how much cash the seller ultimately receives at closing.  If the target is set higher, a seller likely takes home less cash.

Once the NWC target is established in the purchase agreement, the purchase price is adjusted based on the difference between the target NWC and the actual NWC at closing.

Because the final working capital number cannot be determined immediately at closing, the process typically works as follows:

• An estimated working capital amount is used at closing.
• The final working capital is calculated 30–90 days after closing.
• A purchase price adjustment is made based on the difference.

The adjustment generally works as follows:

• If closing NWC is higher than the target, the buyer pays the seller the difference.
• If closing NWC is lower than the target, the purchase price is reduced.

Today, more than 90% of private company transactions include a working capital adjustment, making it one of the most important financial provisions in a purchase agreement.

Why Working Capital Planning Matters

For sellers, working capital planning  should begin months—or even years—before a transaction occurs.  Establishing optical levels of working capital is not only important at the time of sale but will improve cash flow as owners operate their business.  Owners can achieve optimal working capital levels through operational improvements such as:

• Reducing excess inventory
• Accelerating receivable collections
• Managing payables appropriately

Timing is critical. The most effective time to optimize working capital is before discussions with potential buyers begin and before a Letter of Intent is signed. Once negotiations begin, historical financial performance will typically be used to establish the working capital peg.

How the NWC Target Affects Seller Proceeds

When a letter of Intent is signed, a buyer and seller normally still need to agree on a NWC Target.  Consider a simplified example where the purchase price was determined in the letter of intent but the NWC Peg was established during the due diligence process and set at two different levels.

Ultimately, more value was placed on goodwill, assuming the fixed asset value would not change.  In this scenario, a lower working capital target increases the seller’s cash proceeds by $500,000 because less value must remain in the business at closing.

This example illustrates why understanding working capital mechanics early in the process can materially affect the outcome of a transaction.

The Role of Accounting Methods

Another important factor is how working capital is calculated.

Many purchase agreements reference GAAP (Generally Accepted Accounting Principles) when defining working capital. However, many privately held companies maintain financial records on a tax basis or another accounting method.

These differences can create significant discrepancies between:

• historical financial statements, and
• the working capital calculated under GAAP during the transaction process.

For sellers, identifying these differences early helps avoid surprises during due diligence or purchase price negotiations.

Key Questions Sellers Should Ask

As part of transaction planning, business owners should work with their advisors to understand how working capital will affect the deal.

Important questions include:

1. What is my current working capital based on assets and liabilities likely to be included in the acquisition?
2. How has working capital trended over the past 24 months?
3. What level of working capital is actually required to operate the business?
4. Are there components of working capital that could be considered excess?
5. What accounting framework is used for financial reporting?
6. How does it differ from GAAP?
7. Should the working capital peg be based on historical financial statements to maintain consistency?
8. Are there balance sheet items that could be adjusted under GAAP (such as obsolete inventory, uncollectible receivables, or unrecorded liabilities)?

These discussions can help sellers better anticipate how working capital provisions may affect the final economics of the transaction.

An Alternative Approach: The Locked Box Mechanism

In some transactions—particularly in Europe and increasingly in the U.S.—buyers and sellers may use a locked box mechanism instead of the traditional working capital adjustment.

Under this approach, the purchase price is fixed based on a historical balance sheet date prior to closing. The financial position of the company is effectively “locked” at that point.

From that date forward:

• The buyer receives the economic benefit of the business.
• The seller is restricted from extracting value from the company.

Key Characteristics

• Fixed purchase price at signing
• No post-closing working capital adjustment
• Restrictions on dividends or other value transfers before closing

Benefits

• Greater price certainty
• Faster transaction timelines
• Fewer post-closing disputes

Considerations

Because adjustments are not allowed after closing, buyers must perform more extensive due diligence upfront to ensure the working capital level is appropriate.

Final Thoughts

Working capital provisions are often viewed as a technical component of a transaction, but they can have a significant impact on seller proceeds.

Business owners who understand how working capital targets are determined—and who plan ahead—are better positioned to maximize the value they receive when a transaction occurs.

Working with experienced transaction advisors can help buyers and sellers navigate these complexities and avoid costly surprises during the deal process.

Hawkins Ash CPAs has experienced transaction advisors who can assist with transaction planning and execution. Contact Lisa Cribben (lcribben@ha.cpa) or Chris Lerario (clerario@ha.cpa) to learn more about how we can help guide you through the process.