Working capital in a business acquisition

The basic equation

A common enterprise-value structure is:

Equity proceeds = enterprise value + cash − debt − transaction expenses ± working-capital adjustment

The working-capital adjustment often compares defined closing net working capital with a target:

Adjustment = closing defined net working capital − target net working capital

If closing working capital is $230,000 and the target is $300,000, the $70,000 shortfall generally reduces seller proceeds by $70,000. If closing working capital is $340,000 under the same definition, the $40,000 excess generally increases proceeds. Which way it runs, and whether caps or baskets apply, is whatever the signed agreement says.

Define every line before setting the number

Account	Common question	Buyer diligence
Accounts receivable	Gross, net of reserve, or only eligible/current balances?	Age by invoice and service date; test collections, credits, disputes, and cutoff
Inventory	Cost method, obsolescence, consignment, and physical-count rules?	Count, cost, age, turns, demand, damage, expiration, and ownership
Prepaids	Do they provide post-close benefit and can they transfer?	Inspect invoice, coverage period, refundability, and buyer benefit
Accounts payable	Which operating invoices belong to pre-close periods?	Search subsequent disbursements and unmatched receipts
Accrued payroll/PTO	Who bears earned but unpaid employee obligations?	Reconcile payroll periods, bonuses, commissions, taxes, benefits, and leave
Customer deposits/deferred revenue	Cash received versus remaining cost and refund obligation?	Calculate contract-by-contract performance and cancellation exposure
Cash, debt, taxes, owner balances	Included here or handled elsewhere?	Prevent double counting across the purchase-price bridge

Attach an illustrative calculation to the agreement. “GAAP applied consistently” sounds like it settles the question. For a small company it usually does not — not against undocumented reserves, cash-basis books, owner accounts or deferred revenue.

Choose a target that matches the operating cycle

1. Recast at least 12–24 monthly balance sheets under the proposed transaction definition.
2. Fix cutoff and classification errors consistently across all months.
3. Remove non-operating, related-party, excluded, and truly nonrecurring items.
4. Overlay revenue, backlog, seasonality, supplier terms, billing changes, and growth.
5. Select a target method and test whether it funds a normal post-close operating cycle.

A trailing average looks neutral. It is not. If a landscaping company closes in March before seasonal receivables build, a flat annual average may overstate what normally exists on that date. If a distributor has grown 30%, an old average may underfund the new sales level. Use a monthly peg, same-month history, percentage-of-revenue cross-check, or another documented method where the facts require it.

Illustrative seasonal case—not a benchmark

A company averages $300,000 of defined net working capital across the year. But its last three March month-ends were $210,000, $225,000 and $240,000 — because the business builds inventory and receivables later in spring. A March closing at $235,000 is $65,000 below the annual average but near the same-month pattern. Buyer and seller should not argue from different averages; they should select the method in the LOI and test whether $235,000 actually supports April payroll, purchasing, and customer terms.

Negative working capital can still be normal

Some businesses collect before they deliver: subscriptions, memberships, maintenance contracts, deposit-funded work. They can run on negative net working capital, and for them that is normal. It does not make the money free. You inherit the obligation to deliver the service, honour the refunds and fulfil the contracts.

Some businesses run on their customers' money. A gym with prepaid memberships, a contractor with overbillings, a home-care agency carrying payroll ahead of reimbursement: in each case, model the remaining cost and the cash calendar. Do not force every account into a generic positive target.

Estimated close, true-up, and dispute

Publicly filed acquisition agreements show the architecture you are aiming at:

• An estimated closing statement
• A defined target and accounting method
• A post-close calculation
• Review and objection rights
• Supporting records
• Dispute resolution
• Payment

One SEC-filed agreement gives the buyer 90 days for its preliminary statement ^[1] ; another uses 120 days plus an objection and independent-accountant process ^[2] ; another uses a 30-day buyer statement and dollar-for-dollar target comparison ^[3] .

Those are large, negotiated deals — not a template, and not a timetable you have to match. Scale the timeline and the dispute process to your deal. Do not drop any of the parts.

Protect the period before closing

Between the LOI and closing a seller can move the delivered balance — sometimes deliberately, often not. The usual routes:

• Accelerating collections
• Delaying vendors
• Reducing inventory purchases
• Factoring receivables
• Changing deposit terms
• Delaying refunds and payroll

Require ordinary-course operation, consistent collection and payment practices, limits on related-party activity, access to current financials, and notice of material deviations.

Connect working capital to quality of earnings

Earnings and working capital tell different parts of the same story. Revenue growth supported by uncollectible receivables is not quality growth. EBITDA improved by delaying necessary inventory purchases is not sustainable.

A quality-of-earnings review:

• Should bridge revenue
• Gross profit
• Cash
• Receivables
• Inventory
• Payables
• Deferred revenue
• Capital expenditure together

What to settle in the LOI

• Whether price assumes normalized working capital and the preliminary formula.
• Included and excluded accounts, with treatment of cash, debt, taxes, transaction expenses, deposits, and deferred revenue.
• Target period and method, subject to confirmatory diligence.
• Dollar-for-dollar direction, any collar, and whether a holdback supports payment.
• Estimated statement, physical count, post-close statement, objection, access, and dispute mechanics.
• Ordinary-course covenants between signing and close.