How do Working Capital Adjustments Impact Business Sale Price?
- windhorse11
- Nov 17
- 6 min read
When negotiating the sale of your business, arriving at a purchase price is just one of many steps that will determine how much money you ultimately end up with. The purchase price you agree upon will be adjusted based on how you negotiate several other terms of the deal. One of the most important and misunderstood adjustments relates to the transfer of working capital.
When a buyer submits a bid to acquire your company, that bid will likely require that the business will be delivered with sufficient wo
rking capital to operate and maintain the level of earnings that justified the purchase price. Business owners are often surprised to learn that working capital is one of the assets they are selling in a transaction. Many sellers assume that they’ll get to keep Accounts Receivable, for example, because Accounts Receivable represents products or services sold during their ownership period.
Working Capital Adjustment Challenges
Negotiating the transfer of working capital is complicated because the balance sheet accounts that make up working capital change on a daily basis. It’s impossible to know what a company’s working capital balance will be on the proposed closing date. How do you agree on the “fair” value to deliver to the buyer when the values fluctuate throughout the due diligence period?
There are other factors that complicate the transfer of working capital in a business sale:
The potential for seller mischief. Most middle-market companies ($10 million + in annual revenue) are sold on a “cash-free and debt-free” basis, which means that cash is NOT an asset that’s included in the working capital being transferred to the buyer. This creates an unhealthy incentive for the seller to artificially reduce working capital and increase cash before the closing. For example, the seller might sell down inventory or accelerate the collection of accounts receivable, resulting in artificially reduced working capital at closing. You can be sure that buyers will protect themselves from this possibility.
The quality of working capital accounts. Aged accounts receivable, obsolete inventory, aged accounts payable and other factors need to be taken into account to determine the accurate historical and current working capital of the business.
EBITDA Adjustments. Preparing a company for sale involves adjusting EBITDA for one-time revenue and expenses, non-operating expenses and one-time adjustment of accruals. These EBITDA adjustments may impact working capital accounts.
Customer deposits, outstanding gift certificates, or deferred revenue. Businesses that collect customer deposits (current liabilities) before goods and services are rendered, or businesses where some form of deferred revenue is typical, will find that their revenue, deferrals, and customer deposit liabilities will be subject to extra scrutiny by the buyer. The more complicated your customer-related liabilities are, the more you can expect the buyer to examine your related contracts and accounting.
The Working Capital Adjustment Process
The goal of the working capital adjustment process is to:
Ensure that the buyer receives sufficient working capital to operate the business.
Protect the buyer and the seller from short-term fluctuations in working capital.
Avoid manipulation of the purchase price.
When the multi-step working capital adjustment process is negotiated and documented properly, it provides for a predictable transfer of working capital at the closing and minimizes the potential for costly disputes.
Target Working Capital – How much is enough?
The first step is agreeing on how much working capital is appropriate to transfer at closing. The most common target value for working capital is the company’s average working capital over the past year, but shorter or longer periods may be used depending on how the past relates to the projected future state of the business. In cases where a fast-growing company is being sold, for example, historical working capital may not be sufficient. Presumably the buyer is paying you a premium for your fast growing company and they’ll want enough working capital at closing to continue that growth. In these situations, some extrapolation based on historical trends and projected growth are required.
Working Capital Formula
The next step is to clearly define the formula that will be used to calculate the company’s working capital. In it’s simplest form, the formula is
Non-Cash Current Assets - Current Liabilities = Net Working Capital
Net Working Capital is typically comprised of operating current assets and operating current liability accounts. Current asset components usually include Accounts Receivable, Inventory, and certain prepaid costs; less contra accounts for Allowance for Bad Debts and/or Reserve for Inventory Obsolescence. Current Liability components are typically Accounts Payable and certain Accrued Liabilities. The accounts included can vary widely with the nature of the business being sold. Buyers and sellers will negotiate which accounts are most appropriate to include.
The target working capital value and the formula for calculating working capital should be clearly defined in the Letter of Intent. Buyers are often content to postpone detailed working capital negotiations until they’ve completed their financial due diligence. They want an opportunity to test the accuracy of working capital accounts and to better understand the likely working capital requirements after the close. But it’s far better for sellers to establish a clear working capital framework in the Letter of Intent. Deferring these negotiations leaves the seller vulnerable to purchase price adjustments and disputes that can derail a deal entirely. If you’ve agreed on a purchase price without agreeing on a methodology for defining working capital adjustments, then you don’t really have a deal yet.
Due Diligence to Closing and Beyond
During due diligence, the buyer will closely scrutinize the company’s historical financials, including current asset and liability accounts to verify that the target net working capital value is appropriate. Buyers may question the quality of the seller’s current assets (e.g. Is all the AR collectable? Is all the inventory saleable?) or suggest that some current liabilities be excluded as debt that should be paid by the seller.
If the seller is well prepared before the sale and working capital terms are negotiated by someone who understands the merger and acquisition process, there should be no substantive changes to the working capital terms during due diligence.
Estimated Working Capital at Closing
A few days before the closing, the Seller’s team will estimate the Company’s closing day working capital balance. This estimate will be used for the closing day settlement process. If the estimated working capital at closing is lower than the target working capital, then the purchase price will be adjusted lower to compensate the buyer for the lower level of working capital being delivered. If the estimated working capital is higher than the target working capital, the purchase price will be adjusted higher to compensate the seller for the extra working capital delivered.
The Working Capital True-Up Process
The purchase agreement will call for a true-up process to happen 60 to 90 days after the close. At that time, the buyer will determine the actual working capital on the day of closing. A physical inventory at closing will establish inventory levels. Most accounts receivable at the day of closing will have been collected by this point and aged accounts may be omitted from the true-up. If any invoices were omitted from Accounts Payable at the closing, those will have been entered, etc. If the actual working capital delivered is higher than the estimate used for the closing, then the buyer will compensate the seller for the difference, and vice versa.
Managing Buyer Expectations for a Smooth Closing
Balancing the working capital interests of the seller and the buyer is part of the deal negotiation process and there are many opportunities for conflict. Given the competing interests at work and the day-to-day volatility of working capital, it’s important to establish a framework for handling working capital early in the negotiation process. This is done through pre-sale preparation and adjustment of historical financials, anticipating the buyer’s position and then managing buyer expectations from the first disclosures through to the closing.
About Venture 7 Advisors:
Venture 7 Advisors is a team of merger and acquisition advisors who assist the owners of small and mid-sized companies to plan and complete the sale of their business. We find the best buyer to meet each business owner’s financial and legacy goals. We represent clients in consumer products, distribution, manufacturing, B2B services, construction, telecommunications, and eCommerce from offices in Burlington, Vermont, the Hudson Valley, New York, and Western Massachusetts.
We're here to talk about your situation, provide information, discuss your options, and put things in perspective. Contact us at any time:
Bryan Ducharme
Managing Partner
Mobile: 802 578 6462
