A working capital adjustment is a post-closing true-up that adjusts the purchase price based on the actual working capital delivered at closing vs an agreed-upon target ('the peg'). If working capital at closing exceeds the peg, the buyer pays the seller the excess; if it's below the peg, the seller refunds the buyer. The peg is typically set at the trailing 12-month average and can shift the final purchase price by hundreds of thousands of dollars in unexpected directions.
Working capital adjustments exist because buyers expect to receive a 'normal' level of working capital with the business, enough accounts receivable, inventory, and other operating assets to run the business without immediate additional investment. Without an adjustment, a seller could strip working capital before closing (collect receivables, run down inventory, delay paying payables) and effectively transfer cash to themselves at the buyer's expense.
Setting the peg is the most consequential and most negotiated element of the working capital adjustment. The peg is typically based on the trailing 12-month average working capital, but the definition of working capital (which items are included or excluded), the calculation methodology (GAAP vs management adjustments), and the time period (12 months vs 6 months vs the prior fiscal year) all materially change the number. A peg set $500K too high effectively reduces purchase price by $500K when the post-closing true-up runs.
The true-up process: at closing, the seller delivers an estimated working capital number based on the closing balance sheet. The buyer then has typically 60-120 days post-closing to prepare a final working capital calculation. If the buyer's calculation differs from the seller's estimate, dispute resolution procedures kick in, usually a window for negotiation followed by binding arbitration by a designated accounting firm if no agreement is reached.
Common disputes: classification of items (is it working capital or capital expenditure? is it operating or financing?), valuation of inventory (what's the right reserve for obsolete inventory?), collectability of receivables (what reserve for bad debts?), and timing items (year-end accruals, prepaid expenses, deferred revenue). For Northern Suburbs business sellers, a clean sell-side analysis of working capital before going to market, and a defensible methodology for setting the peg, is one of the highest-ROI activities in the entire sale process.
Key facts
- Working capital adjustment: post-closing true-up based on actual vs target ('peg') working capital
- Typical peg: trailing 12-month average working capital
- Common definition: current assets (excluding cash) minus current liabilities (excluding debt)
- Excludes: cash (delivered debt-free, cash-free) and indebtedness (the buyer pays off seller debt at closing)
- True-up window: typically 60-120 days post-closing for buyer to deliver final calculation
- Disputes resolved through: negotiation, then binding arbitration by a designated accounting firm
How does 'cash-free, debt-free' interact with the working capital adjustment?
Most lower-middle market deals are structured as 'cash-free, debt-free, with a normalized working capital adjustment.' This means the seller keeps all cash on the balance sheet at closing, the seller pays off all debt at closing (or the buyer pays it off and reduces the price by the same amount), and the working capital delivered must equal the peg. Cash and debt are intentionally excluded from the working capital calculation because they're handled separately. A common error: classifying items that are really debt-like (deferred revenue from prepaid customers, accrued bonus liabilities) as working capital when they should be treated as debt.
Can working capital adjustments reduce the purchase price by a lot?
Yes, especially for businesses with significant seasonality, large customer concentration in receivables, or substantial inventory levels. We've seen working capital adjustments swing the final purchase price by 5-10% of the headline number, sometimes hundreds of thousands or more than $1 million for larger deals. The biggest unexpected reductions usually come from: (1) inventory reserves the buyer applies that the seller didn't have on the books; (2) bad debt reserves the buyer applies on receivables; (3) reclassification of items the seller treated as cash-equivalents but the buyer considers working capital.
