Working Capital Adjustments in M&A

In any M&A transaction, valuation discussions often centre on headline metrics such as earnings, cash flow, and asset value. Yet, one crucial factor that can materially affect both price and post-deal performance frequently receives less attention: working capital.

Representing the short-term funds necessary to keep a business operational, working capital is one of the most imminently important points in an M&A deal. For buyers, these funds will help them to keep the business trading in the immediate post-deal period. For sellers, it represents money they have earned, but that they are leaving behind as part of the deal.

Naturally, this creates a tension. Buyers will want to maximise the amount of working capital within a business they acquire, or gain a more favourable purchase price. Vendors, meanwhile, will seek to maximise the amount that they take out, or will aim to compensate through a higher purchase price.

In order to prevent this tension scuppering deals, a mechanism called a working capital adjustment will typically be used to provide some form of protection to both parties in the event that a pre-agreed working capital target is either exceeded or not met.

Not surprisingly negotiations around working capital targets and adjustments are fraught with difficulties themselves, posing one of the main points at which disputes could arise during a deal.

In this piece, we examine working capital adjustments in depth, looking at typical structures, key considerations from both a buyer and seller point of view, potential pitfalls and solutions that can help to keep a deal on track.

Working capital in M&A
Working capital refers to the short-term funds that enable a business’ day-to-day operations to proceed smoothly. Generally, it is defined as a business’ current assets minus current liabilities. This excludes a company’s surplus cash and debts, hence deals occurring on a “cash-free, debt-free basis”, - i.e. all cash not needed for daily operations is removed prior to closing, while the seller uses company funds or their own cash to pay off outstanding debts prior to completion.

Working capital, therefore, generally encompasses cash required for daily operations, inventory and accounts receivable, minus current liabilities such as accounts payable and short-term debts or other obligations.

Working capital is an important part of M&A simply because this liquidity means that the business can run smoothly from the get-go post-sale. It ensures, in theory, that a buyer can step into the business on day one and have it continue operating without the immediate need to infuse additional capital.

As outlined above, the importance of working capital can create a tension between the buyer’s desire to maximise the working capital in the business when they take over and the seller’s desire to maximise the amount of surplus cash they can take out of the business, either for themselves or to service debts.

The value of a business will assume a normal level of working capital, which might be calculated by using accounts to produce a historical mean figure. This will often allow for temporary fluctuations that might occur, for example, during slower sales seasons.

However, the aim for both parties is to avoid a scenario in which working capital differs significantly from a historical level, which (depending on whether the figure was higher or lower) would represent a windfall for one at the expense of the other.

To combat this, parties involved in an M&A negotiation will seek to set a working capital target (or “peg”) in the Letter of Intent (LOI) to provide a benchmark for working capital upon completion of the deal (often known as a closing balance).

Working capital adjustments
This working capital target will typically be bolstered by the inclusion of a working capital price adjustment mechanism. This, simply put, is a pricing lever that directly changes the equity value of a transaction depending on actual working capital at completion (the locked-box date) compared to the target figure.

If the closing balance of working capital exceeds the target, the purchase price is increased by the surplus amount - directly compensating the vendor. Alternatively, if there is a shortfall in the closing balance compared to the target, the purchase price is decreased accordingly, thereby compensating the buyer. This process of reconciling the price is often referred to as the “true up”.

In this way, the working capital adjustment seeks to simultaneously ensure that: there is sufficient working capital to support short-term operations; the buyer and seller are both protected against unexpected working capital fluctuations prior to closing; and to deter the seller from taking irregular actions to limit the amount of working capital in the business upon closing.

Naturally, this situation (in which the gain of one party directly correlates to the loss of another), creates a significant scope for potential disputes, ranging from defining working capital and deciding on a normalised working capital figure for the target company, to establishing a working capital target or peg and settling the mechanism post-closure.

Given this, as well as the significant impact that working capital adjustments can have on final purchase prices and the fact that such levers need to be specifically tailored to each deal, buyers and sellers should be prepared to dedicate significant time to working out the structure and pre-empting potential disputes.



In M&A we separate “operating working capital” from net debt. Cash at bank and interest-bearing debt sit in the net-debt adjustment; the peg and true-up focus on trading items only. In the example balance sheet above, operating NWC is £2.6m (cash excluded). If closing NWC lands below the peg, price falls pound-for-pound; if it lands above, price rises. This is why consistent policies on receivables, stock provisioning and cut-off matter more than a one-off month-end snapshot.


Buy and sell-side priorities
While avoiding disputes is critical and some compromise may be needed on both sides, this does not mean that buyers and sellers shouldn’t argue strongly for terms that suit them.

Key priorities for buyers

Sufficient day-one liquidity - The most imminent priority for buyers is to ensure that there is sufficient day-one working capital in the business for them to take over the business in a fully operational state without the need to inject additional cash or borrow in order to support short-term operations.

Typical critical aspects of day-one liquidity include, sufficient working capital, treasury integration in order to ensure control over cash and access to accounts, ensuring that banking partners are notified so that salary and vendor payments can continue uninterrupted and, in the event of a distressed deal, sufficient bridge financing to ensure liquidity to keep the business afloat.

In terms of calculating whether working capital is sufficient (or to determine whether a working capital peg figure is accurate), buyers can quickly gauge this by using a working capital ratio.

A working capital ratio differs quite significantly from a working capital figure (current assets minus current liabilities) and is a solid generalised measure of short-term liquidity. A quick working capital ratio can be gathered by dividing the value of current assets by current liabilities.

A working capital ratio in excess of 1 typically indicates good working capital health, with a figure between 1.5 and 2 generally seen as extremely healthy and sufficient for covering short-term operations. So, for example, a business with £8 million in current assets and £4.5 million in current liabilities would be seen as having strong working capital, with 8 divided by 4.5 producing a working capital ratio of slightly under 1.8.

A figure under 1 is a potential warning sign that the business has poor working capital and may struggle to meet its short-term obligations. On the other hand, a very high ratio (e.g. a ratio of 2.5+) may indicate inefficient use of assets that could limit growth.

Push for high peg on robust average - Critical to ensuring as much day-one working capital as possible will be pushing for a higher working capital target. This will not only alleviate the risk of not having sufficient funds to support short-term operations, it will also mean the buyer is protected if fluctuations in working capital mean that the closing balance is below a normalised level.

Insisting on using a period of time that demonstrates a true normalised level of working capital to establish the peg figure will help to produce a target that is an accurate reflection of the funds necessary to support day-to-day operations.

A period of 12-months is typically seen as favourable by buyers, who often use a 12-month normalised EBITDA or cash flow figure when measuring the enterprise value of a business. While a vendor may seek to use a period that results in a lower peg, thus a more achievable target and the possibility of an increased purchase price if there is a surplus, buyers will want a figure that is more complete.

Utilising a 12-month figure that is adjusted for seasonality and one-offs will produce an accurate level of normalised working capital, protecting the buyer in the event that a deterioration in working capital prior to the deal closing is reflected in a reduced price.

Tight definitions and inclusions - For buyers, a key priority is to ensure that “working capital” is tightly and comprehensively defined in the sale purchase agreement (SPA) so the peg reflects the business’ real funding requirements and cannot be manipulated at completion.

This involves clearly listing all trading working capital items (trade receivables, inventory, trade payables, prepayments and accruals) and then explicitly deciding how to treat “debt-like” balances such as tax liabilities, payroll and bonus accruals, customer deposits and onerous provisions, either within working capital or as separate debt-like adjustments.

Buyers will also want the SPA to require that completion accounts are prepared on a basis consistent with the historical accounts used to set the peg, so that the seller cannot change accounting policies, estimates or classifications to improve the apparent closing working capital position and trigger a higher price.

Protect against “window-dressing” - Buyers will want to ensure that sellers don’t artificially boost working capital in the run-up to completion through tactics such as stretching creditors, aggressively collecting from customers or running inventories down to unsustainably low levels merely to hit the peg. Using a 12 month calculation period, adjusted for seasonality and one-offs, rather than a single month-end, is a common solution, as this makes short-term manipulation much harder.

Buyers will also often seek “ordinary course of business” covenants expressly restricting unusual collection or payment practices or material changes to customer or supplier terms between signing and completion. This will mean that any deliberate window-dressing can be challenged as a contractual breach as well as through the true-up.

Structure a buyer-friendly true-up - Finally, buyers will want the mechanics of the working capital true-up to be clear, timely and enforceable so that any shortfall against the peg translates efficiently into a price reduction.

This will typically mean agreeing a short but realistic timetable for preparing completion accounts, a defined period for the buyer to review and raise objections and a requirement that the accounts are prepared to a high standard with full access to underlying records and finance staff.

Buyers may also be advised to push for a robust independent expert determination mechanism with a clear mandate to resolve only the items in dispute, ensuring that technical accounting disagreements over working capital are settled quickly and with limited scope for re-litigating the overall commercial deal.

Key seller priorities
Minimise purchase price erosion by arguing for a low peg - Sellers will generally seek the lowest defensible working capital target that still supports the buyer’s requirement for sufficient day-one liquidity, so that any “excess” working capital delivered at completion crystallises as additional purchase price rather than being left in the business for free.

This requires sellers to prepare their own robust working capital analysis (including ratios, trends and seasonality) to evidence that a lower peg is consistent with the company’s historic ability to operate without liquidity stress.

Use a reference period that flatters the business[/i] - When agreeing the peg, sellers typically push for a reference period that reflects improved trading and more efficient working capital management. For example, recent quarters where debtor days have shortened or inventory has been better controlled, rather than historical periods where working capital was structurally higher.

The goal is still a “normalised” level, but one that factors out one-off spikes, thereby avoiding a target that bakes in unusually high working capital and creates downside risk at completion.

Narrow the scope and carve out exclusions - Sellers will try to narrow what is treated as working capital and to exclude as many “debt-like” or judgement-heavy items as possible, so that these are dealt with separately (for example through the debt adjustment or specific indemnities) rather than depressing the working capital target.

This often involves negotiating the treatment of tax balances, payroll and bonus accruals, customer deposits, onerous provisions and other reserves, while pushing for accounting policies and estimates consistent with historic practice, but not unduly conservative.

Reduce post-completion uncertainty and dispute risk - To limit exposure to post-completion price reductions, sellers typically push for clear, mechanical formulas and objective definitions in the SPA to ensure that minor variances do not trigger an adjustment.

Where possible, sellers may prefer a locked-box structure so that there is no open-ended working capital true-up, with protection instead achieved through tight covenants, rather than a broad completion-accounts process.

Optimise working capital well ahead of sale - Well before launching a process, sellers will benefit from actively managing working capital to improve metrics in a sustainable way, tightening credit control, cleaning up aged receivables, rationalising obsolete or slow-moving inventory and addressing long-outstanding accruals and provisions.

This supports a lower, seller-friendly peg while reducing the buyer’s ability to argue that historic working capital levels are distorted or indicative of underlying operational weaknesses.

Handling common disputes

Dispute - Definition and scope of working capital - Parties often disagree over whether specific balances belong in working capital or are “debt-like”, such as tax liabilities, bonus accruals, deferred revenue or customer deposits. Ambiguity in the SPA drafting or schedules can lead to competing classifications at completion, with each side arguing for treatment that favours its economic position.

Solution - Use a schedule-based definition - Attach a working capital schedule to the SPA that lists which items are included in working capital and which are treated as cash or debt-like, providing examples for key judgement areas (e.g. customer deposits, deferred revenue, tax, bonuses).

Add an accounting hierarchy stating that working capital is calculated using specific agreed policies and consistent past practice, ensuring the classification at completion matches the basis used to set the peg.

Dispute - Methodology and accounting policies - Disputes arise when the peg is calculated using one set of accounting policies or estimates (e.g. conservative bad-debt or stock provisions) but the completion accounts use another. Even subtle changes in provisioning, cut-off or classification can materially change the reported working capital and therefore the adjustment, prompting arguments that the mechanism is being manipulated.

Solution - Lock in consistent policies - Include explicit language that the same accounting policies, estimates and cut-off rules used in the reference period/peg calculation must be applied in the completion accounts, with any deviations either prohibited or adjusted out of the true-up. Show worked examples such as an illustrative completion-accounts calculation to reduce room for interpretation and to guide any independent expert.

Dispute - Normalisation, seasonality and one-offs - The parties may later disagree over whether the peg appropriately reflected seasonality, growth and non-recurring items, especially if the business consistently closes above or below the target post-completion. Typical flashpoints include how to treat exceptional sales, temporary supply chain issues, or one-off receipts/payments that distorted the historic period used to set the peg.

Solutions - Conduct a proper normalisation analysis - Use 12–24 months of monthly data to identify seasonality and one-off events, and explicitly adjust for them when setting the peg, documenting the rationale in a shared workspace.

Consider collars or bespoke treatment - Where volatility is high, agree a peg plus/minus collar, or custom treatment for particularly sizeable items (e.g. large project milestones), so that normal swings stay within the scope and only outliers trigger an adjustment.

Dispute - Quality of working capital and window-dressing - Even where the absolute level of working capital meets the peg, buyers may claim that its quality has been weakened by pre-closing behaviour, such as aggressive revenue recognition, stretched creditors or over-aged receivables. This can lead to disputes over whether the seller breached “ordinary course” covenants or whether additional provisions should be recognised in completion accounts, thereby reducing the price.

Solutions - Strengthen ordinary-course covenants - Require the business to be run in the ordinary course consistent with past practice, with specific prohibitions on unusual payment or collection practices, material changes in terms, or unsustainable inventory reductions; link breaches to both the adjustment and potential warranty or covenant claims.

Enhance monitoring and dispute mechanics - Agree frequent pre-close reporting on days sales outstanding, days payables outstanding, ageing and inventory turns. Build a clear, time-bound completion-accounts and expert-determination process so that any concerns about working capital quality can be escalated and resolved quickly.

Working capital and working capital adjustments are both critical elements of the M&A process and can have a major impact on final purchase price. However, in many deals they remain an overlooked aspect, an omission that can drastically affect not only the value of the deal, but also the scope for harmful disputes.

By dedicating significant time and effort to working capital adjustments and forthrightly advocating for their own interests while remaining open to negotiation, buyers and sellers can ensure that the deal is fairer on both sides and that the potential for disputes to derail the deal (or even flare up post-closing) is minimised.

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