When you’re selling (or buying) a business, the headline number — the purchase price — gets a lot of attention. But overlooking working capital can lead to surprises after closing that eat into your proceeds or force unexpected cash injections. Working capital plays a key role in ensuring the business is ready to operate on Day One under new ownership.
What Is Working Capital in an M&A Transaction
Working capital broadly means current assets minus current liabilities — assets and obligations expected to be settled within roughly one year. In M&A, however, the definition is refined, because buyers and sellers want to make sure the business walks out of the deal with enough resources to continue operations without needing extra cash or capital.
In M&A you often hear about net working capital (NWC) or “non-cash working capital.” This generally excludes cash and cash equivalents (which the seller usually keeps) and debt or debt-like items (which the buyer often does not assume).
How Working Capital Is Calculated
Here’s how working capital is commonly defined and calculated in transactions:
- Start with current assets needed to run the business: things like accounts receivable, inventory, prepaid expenses.
- Subtract the current liabilities necessary for ongoing operations: accounts payable, accrued expenses, deferred revenue, other short-term obligations that recur.
- Exclude cash, debt, and other non-operating or non-recurring items unless explicitly agreed.
- Sometimes use historical averages (for example, monthly or quarterly NWC over the past 12 months) to set a “working capital target” (sometimes called a peg) agreed between buyer and seller.
Why Working Capital Is Important
- Operational Continuity: Ensures that after closing, the business has enough short-term assets to manage receivables, payables, inventory, etc., without needing extra funds.
- Purchase Price Adjustment: The deal often includes a working capital target. If the actual working capital at closing is higher than the target, the seller may be paid the difference; if lower, the seller may need to reimburse the buyer.
- Risk Mitigation: It prevents the buyer from inheriting a business in which short-term obligations or operating necessities are underfunded, which could harm operations immediately post-transaction.
- Clarity & Negotiation Leverage: Sellers who understand and prepare for working capital expectations can negotiate more effectively, avoid surprises, and secure better terms.
Key Risks
- The seller under-estimates working capital needed for seasonality, slow payables, inventory turns, or receivables.
- In agreement documents (LOI or Purchase Agreement), definitions are vague or inconsistent, leading to disputes over what constitutes included vs excluded items.
- Buyers assume liabilities or obligations that the seller did not clearly disclose.
- Post-closing adjustments lead to unexpected reductions in final proceeds for sellers who didn’t anticipate them.
Best Practices
- Define working capital measures up front in your LOI and Purchase Agreement, with clarity on what is included/excluded.
- Use historical data (seasonal or monthly averages) to set realistic working capital targets.
- Ensure financial statements are clean, consistent, and reflective of what “ordinary course of business” working capital looks like.
- Document non-recurring items, and be ready to explain or exclude them.
- Build in buffers — avoid setting targets too tight such that small fluctuations work against you.
Sources:
- BDO — Importance of Net Working Capital in M&A
- Morgan & Westfield — Net Working Capital: A Complete Guide
- JAH Law — Net Working Capital Targets in M&A Transactions
- KMCo — Understanding What Net Working Capital Is in M&A Transactions
- Embarc Advisors — Net Working Capital in M&A: Definition, Target & Risks
- Kroll — Navigating Working Capital in M&A Transactions