How Does Working Capital Affect the Purchase Price in a Dallas M&A Deal?

On this page

1. What does working capital mean in an M&A deal?
2. Why do buyers and sellers agree on a working capital target?
3. How does the working capital adjustment change the purchase price?
4. How should the working capital target be set?
5. What actually goes into the working capital calculation?
6. How do asset sales and cash-free, debt-free deals change the math?
7. Where do working capital disputes usually come from?
8. What happens to working capital at and after closing?
9. What does this look like in a Dallas-area deal?
10. Three questions to ask before agreeing to a working capital adjustment
11. Frequently asked questions

In brief

Working capital can directly change what a buyer pays at closing. The parties agree on a target, then compare it with actual working capital at closing. Above the target, the price may go up. Below it, the price may go down. A $200,000 shortfall against a $1 million target may turn a $10 million price into $9.8 million.

Key Takeaways

1. 01Model working capital early, because a $10 million price may not mean $10 million paid at closing.
2. 02Set the target from what the business normally needs, testing for seasonality, growth and unusual items.
3. 03Define exactly which receivables, inventory, payables, accruals and cash count, and how each is valued.
4. 04Match the working capital formula to the assets and liabilities actually transferring, especially in an asset sale.
5. 05Spell out the closing estimate, final calculation, review period and dispute process in the purchase agreement.

The short answer is that working capital can directly change the amount a buyer pays for a business at closing. The purchase price usually assumes the buyer is receiving a business with a normal level of working capital. The parties agree on a working capital target before closing, and if actual working capital comes in above or below that target, the purchase price may go up or down.

So if the parties agree to a $10 million purchase price, that doesn’t always mean $10 million is the amount paid at closing. The working capital adjustment can change that number, and if the formula isn’t understood early, it can create a very unpleasant surprise near closing. That’s why I think working capital should be modeled before the purchase agreement is nearly finished, so the legal language, the accounting methodology and the purchase price economics all match.

What does working capital mean in an M&A deal?

Working capital is generally the short-term operating assets and liabilities a business uses to run day to day. That may include accounts receivable, inventory, prepaid expenses, accounts payable and accrued operating expenses. But in an M&A transaction, I wouldn’t simply assume that working capital means current assets minus current liabilities from the company’s balance sheet.

The purchase agreement usually has its own definition, and that definition may include certain accounts and exclude others. Cash is often excluded. Debt is usually dealt with separately. Certain tax items may be excluded, and some accrued liabilities may be included while others aren’t.

So when someone tells me a deal has a working capital adjustment, one of my first questions is: what exactly counts as working capital under this agreement? The definition determines what goes into the purchase price calculation.

Why do buyers and sellers agree on a working capital target?

The reason is fairly practical. The buyer expects to receive an operating business, not just the equipment, the customer relationships or the name, with enough normal operating assets to keep running after closing.

Take a simple example. Assume a Dallas-based industrial services company normally carries about $2 million of accounts receivable and about $1 million of accounts payable and other operating liabilities. Very simply, the business normally operates with about $1 million of net working capital. Now suppose the seller collects nearly all of the receivables immediately before closing but leaves the normal payables in the company. The buyer would receive a business that needs cash almost immediately just to fund normal operations. That’s generally not what the buyer thought it was purchasing.

Figure 1

Why a buyer of a Dallas-based industrial services company cares about the balance sheet on closing day.

What the business normally carries

$2M accounts receivable

$1M payables and operating liabilities

$1M net working capital

Seller collects nearly all receivables before closing

Receivables nearly all collected

$1M payables stay in the company

Buyer funds operations almost immediately

The opposite can happen too. If the business is delivered with substantially more working capital than the parties assumed when they negotiated the price, the seller may argue that the buyer is receiving more value than it bargained for. That’s why the parties establish a target. You may hear it called the working capital target, the working capital peg or simply target working capital. Whatever the name, we’re establishing the normal amount of working capital the business should have at closing.

How does the working capital adjustment change the purchase price?

The basic formula is pretty simple. We usually compare actual working capital at closing to the agreed target. If actual working capital is above the target, the seller may receive an increase in the purchase price. If it’s below the target, the purchase price may be reduced.

For example, assume the parties agree to a $10 million purchase price, and they also agree that normal working capital is $1 million. At closing, actual working capital is only $800,000. That creates a $200,000 shortfall, and depending on the purchase agreement, the price may be reduced by $200,000. If actual working capital is $1,200,000 instead, the seller may receive a $200,000 increase.

Figure 2

The basic math against the target.

Working capital at closing	Compared with the $1 million target	Possible effect on the $10 million price
$800,000	$200,000 shortfall	Price may be reduced by $200,000
$1,000,000	At target	No adjustment
$1,200,000	$200,000 surplus	Seller may receive a $200,000 increase

Figure 3

Try it: move the closing number.

Working capital delivered at closing

$800,000

$600,000$1,400,000

Against the $1,000,000 target

$200,000 shortfall

Possible effect on the price

Reduced by $200,000

$10 million price becomes

$9,800,000

That’s the general idea, but the math usually isn’t where the difficult negotiation happens. The hard part is deciding the right target and what goes into the calculation, and those two questions can move a lot of money.

How should the working capital target be set?

There’s no simple number that works for every business. The target should reflect the normal working capital needs of that particular company. One common approach is to look at historical working capital over a period of time, maybe 12 months, maybe another period that better reflects the business.

Even an average can point in the wrong direction, though. A distributor may carry much more inventory during part of the year. A service company may have large receivables at certain points in its billing cycle. A company may historically pay vendors at the end of the month but close the transaction in the middle of the month. So I don’t think the analysis should simply be: take 12 balance sheets, average the number and call that the target.

The parties should understand what’s driving the number. Is the business seasonal? Has it grown, or has the customer mix changed? Are receivables being collected more slowly? Were there unusual items during the measurement period? The purpose of the target isn’t to create an arbitrary accounting number. It’s to determine what a normal level of working capital looks like for the business the buyer is actually acquiring.

Figure 4

What can make a 12-month average point in the wrong direction.

SeasonalityA distributor may carry much more inventory in part of the year.

Billing cycleA service company may have large receivables at certain points.

Vendor timingPaying at month-end, closing at mid-month.

GrowthAn old period may not reflect the business today.

Customer mixHas it changed during the period?

Collection speedAre receivables being collected more slowly?

Unusual itemsAnything that distorts the measurement period.

That’s also why an M&A transaction isn’t just a legal exercise. I can draft the adjustment, define working capital and build the dispute mechanism, but somebody needs to understand the company’s actual numbers. Before the parties agree on the target, I want a transaction accountant, quality of earnings advisor or other financial advisor asking what normal working capital has actually been, which accounts belong in it and whether the receivables are collectible. Those questions shouldn’t first be asked a few days before closing. If the adjustment can move the price by several hundred thousand dollars or more, it’s part of the economics of the deal and deserves to be analyzed like one.

What actually goes into the working capital calculation?

The answer turns on the definitions. Accounts receivable are often included because they represent money customers owe the business for work already performed or products already sold, but even here there can be questions. Are all receivables counted at full value? What about an invoice that’s six months overdue, a customer who is disputing an invoice, or an account the company may never collect? A $1 million receivable isn’t necessarily worth $1 million if everyone knows the customer isn’t going to pay it, so the accounting methodology matters.

For a business that carries inventory, inventory may be part of working capital, but we need to know how it’s valued. What about obsolete inventory, damaged inventory, or inventory that hasn’t moved in several years? A number on the balance sheet doesn’t mean the buyer and seller agree that every dollar of it has the same economic value.

Accounts payable are generally operating obligations owed to vendors and suppliers. If the buyer is taking them with the business, they may reduce working capital, but we need to understand which payables are actually transferring, especially in an asset sale. Accrued payroll, bonuses, commissions, vacation, customer deposits and other accrued obligations may also affect the calculation. Some will be included, and some may be handled separately.

Figure 5

The schedule behind the definition.

Item	Common treatment	The question to ask
Accounts receivable	Often included	Are overdue or disputed invoices counted at full value?
Inventory	May be included	How are obsolete, damaged or slow-moving items valued?
Accounts payable	May reduce working capital	Which payables are actually transferring?
Accrued obligations	Some in, some handled separately	Payroll, bonuses, commissions, vacation, customer deposits?
Cash	Often excluded	Is there a minimum cash requirement?
Debt	Usually dealt with separately	Paid off at closing, or otherwise dealt with?
Certain tax items	May be excluded	Does the definition say so?

That’s why I don’t like using the phrase “working capital” as though it answers the question by itself. The schedule behind the definition matters.

How do asset sales and cash-free, debt-free deals change the math?

Structure matters too. In an equity sale, the buyer generally acquires the company itself, and its receivables, payables, contracts and other assets and liabilities stay inside it unless something is specifically taken out. In an asset sale, we’re selecting which assets the buyer receives and which liabilities it assumes (see Asset or Equity Purchase: What Changes?). That can create a mismatch if the working capital formula isn’t coordinated with the asset and liability provisions.

Assume the buyer receives the seller’s accounts receivable, but the seller keeps responsibility for the related accounts payable. If we simply calculate working capital as though both sides of the balance sheet are transferring, the formula may not reflect the actual deal. Or the seller retains certain payables, but the buyer also receives a credit for them in the working capital calculation, and now we need to make sure the seller isn’t charged twice for the same liability. Issues like these look small in a draft but have a direct dollar impact at closing. In an asset sale, I want the working capital definition to line up with the assets the buyer actually receives, the liabilities it actually assumes and how each is treated in the purchase price calculation. Those provisions should tell the same economic story.

Cash creates a lot of confusion in private company transactions. Many acquisitions are negotiated on a cash-free, debt-free basis, which usually means the seller keeps the company’s cash, the company’s debt is paid off or otherwise dealt with, and the buyer receives the business with an agreed level of working capital. Not every transaction works exactly that way. The buyer may need a certain amount of cash to remain in the business, cash may be included in the broader purchase price formula, or there may be a separate minimum cash requirement.

So I wouldn’t assume that because a deal is described as cash-free, debt-free, the seller can sweep every dollar out of the operating account before closing. If the business has payroll due two days after closing, someone has to fund it, and the purchase agreement should say how.

Where do working capital disputes usually come from?

In my experience, the hardest working capital issues aren’t complicated math. They come from the assumptions behind it, and a few areas deserve particular attention.

1. 01

   A target that’s wrong

   Maybe it was based on an old period that no longer reflects the business, the company has grown significantly, the business is seasonal, or the target was negotiated at the LOI stage without anyone doing enough analysis (see What Should an LOI Resolve Before Diligence Begins?). If the target itself is wrong, even a perfectly accurate closing calculation can produce a bad economic result.

2. 02

   Different accounting methods

   If the seller historically treated an item one way and the buyer treats it differently after closing, the buyer’s calculation can produce a lower working capital number. That’s why a purchase agreement often addresses consistency with historical accounting practices in addition to broader accounting standards.

3. 03

   Receivables that aren’t really collectible

   The seller may say there are $2 million of receivables on the balance sheet, while the buyer says yes, but $500,000 of those receivables are seriously past due. Now we have to determine how the agreement treats those accounts.

4. 04

   Liabilities counted twice

   I pay close attention to this one. If an obligation already reduces the purchase price through the working capital calculation and the seller also has to pay it separately, we need to make sure the economic effect isn’t being duplicated. The reverse can happen too: a liability is excluded from working capital because the seller is supposed to pay it separately, but the document fails to clearly require the payment. The different sections of the agreement have to work together.

What happens to working capital at and after closing?

Most of these adjustments involve two stages. First comes the estimate. Before closing, one side, often the seller, prepares an estimated closing statement showing the working capital the company is expected to have as of closing, and that estimated number is used to calculate the amount paid at closing.

But the books may not be fully closed yet. Invoices may still be coming in, receivables may still be collected, and certain accruals may not be final. So after closing, the buyer typically prepares a final calculation based on the actual closing numbers. The seller then gets a period of time to review it. If the parties agree, the difference is paid. If they disagree, the purchase agreement should tell them what happens next.

Figure 6

The two stages of the adjustment.

1. EstimateBefore closing, one side prepares an estimated closing statement.
2. ClosingThe estimate is used to calculate the amount paid.
3. Final calculationThe buyer typically prepares it from actual closing numbers.
4. Seller reviewA set period to review and object.
5. Payment or disputeThe difference is paid, or the agreement says what happens next.

The agreement should answer several questions. Who prepares the closing calculation, and how much time do they have? What records can the seller review? How long does the seller have to object, and what happens to items that aren’t disputed? Who decides unresolved accounting issues, and who pays the accountant or other professional handling the dispute? These provisions may not seem exciting during negotiation, but they become very important when several hundred thousand dollars is in dispute after closing.

Three questions to ask before agreeing to a working capital adjustment

Working capital can look like an accounting detail, but it isn’t. Before agreeing to the adjustment, I’d ask three questions.

1. 01

   What level of working capital does the business normally need?

   Start with the business, not the formula.

2. 02

   What exactly is included in the calculation?

   If an item matters economically, the parties should know where it appears.

3. 03

   Does the formula match the rest of the deal?

   Nothing should be counted twice, the estimate and the final calculation should use the same accounting rules, and the purchase price section, the asset and liability provisions and the working capital schedule should all fit together.

The mistake is waiting until the end of the deal. The buyer and seller may spend weeks negotiating whether the company is worth $10 million, but until they agree on how much working capital needs to be delivered with the business, they may not know what that $10 million price actually means at closing. When the target, the definitions and the formula line up, the adjustment does what it’s supposed to do: the buyer receives the business it agreed to, and the seller receives the purchase price the parties actually negotiated.

If you’re buying or selling a Texas business, Escamilla Law Office’s mergers and acquisitions practice can work through the working capital terms with you and your accountant. The Transaction Readiness Check is a useful place to start.

Frequently Asked Questions

More answers are on our M&A FAQs page.

About the author

Rick Escamilla

Rick Escamilla is the principal of Escamilla Law Office, which represents buyers, sellers and closely held companies in mergers, acquisitions and related ownership transactions across Texas. Before entering private practice, he worked in investment banking and corporate finance.

Attorney advertising. This article is for general informational purposes only and is not legal advice. Reading it does not create an attorney-client relationship. Escamilla Law Office, 7550 I-10, Ste 800-863, San Antonio, TX 78229. (210) 997-0025.