Why the working capital target, methodology, and closing calculation deserve careful attention

A working capital adjustment can have a direct and sometimes significant effect on the final purchase price in the sale of a business. Although it is often addressed late in the transaction process, the adjustment should be considered early, documented clearly, and calculated consistently. Careful planning can reduce disputes and help both parties understand the economics of the deal before closing.

What Is Working Capital?

For transaction purposes, working capital generally represents the operating assets and operating liabilities needed to run the business on a day-to-day basis. The specific components depend on the company and the terms of the purchase agreement, but they often include accounts receivable, inventory, prepaid operating expenses, accounts payable, and accrued operating expenses.

In a manufacturing business, for example, cash is invested in materials and production before finished goods are sold. A sale creates an account receivable, which is later converted into cash. At the same time, accounts payable and accrued expenses reflect amounts owed to employees, vendors, and other operating partners. Together, these balances (called working capital) support the normal operating cycle.

Cash, debt, income taxes, transaction expenses, and other financing or nonoperating items are commonly excluded from a working capital calculation. However, the purchase agreement should specifically identify included and excluded accounts. The agreement, not a general rule of thumb, ultimately governs the calculation.

Why Buyers and Sellers Establish a Target

A buyer generally expects the acquired business to be delivered with enough working capital to continue operating in the ordinary course immediately after closing. If the business is delivered with too little working capital, the buyer may need to fund the shortfall. If it is delivered with more than the agreed amount, the seller may expect additional consideration.

To address this issue, the parties establish a working capital target, sometimes called a “peg”, in the purchase agreement. At closing, actual working capital is compared with the target. The difference becomes the working capital adjustment and may increase or decrease the purchase price.

Establishing the Working Capital Target

The target is often based on historical working capital over a representative trailing period, such as the prior 12 or 24 months. Selecting the period is only the starting point. The parties also need to evaluate whether the historical amounts reflect the level of working capital required to operate the business under normal conditions.

Factors that may affect the target include:

• Seasonal changes in sales, inventory, or purchasing activity
• Rapid growth or contraction in the business
• Changes in pricing, supplier terms, or customer payment patterns
• Unusual, nonrecurring, or out-of-period transactions
• Changes in accounting policies, estimates, or account classifications
• The timing of payroll, vendor payments, customer billings, or other closing-date activity
• Unclear definitions. The agreement does not clearly define the accounts, calculations, or accounting principles used in the adjustment.
• Inconsistent accounting. The closing balance sheet applies policies or estimates differently from those used to determine the target.
• Cutoff errors. Revenue, receivables, inventory, payables, or accrued expenses are recorded in the wrong period around the closing date.
• Classification questions. The parties disagree about whether a balance is operating, financing, debt-like, transaction-related, or otherwise excluded.
• Reserve and estimation differences. Accounts such as doubtful accounts, obsolete inventory, rebates, returns, bonuses, and warranty obligations may require judgment.
• Spreadsheet and formula errors. Large or complex workbooks may contain incorrect signs, broken links, hard-coded amounts, inconsistent ranges, or simple addition and subtraction mistakes.

Establishing an appropriate target is often more art than science. Buyers may prefer a higher target because it provides more working capital at closing, while sellers may prefer a lower target because the adjustment is more likely to increase the purchase price. A supportable analysis, grounded in the company’s operating cycle and historical records, can help narrow the difference.

Consistency Is Critical

One of the most important principles in a working capital adjustment is consistency. The methodology used to calculate working capital at closing should generally follow the methodology used to establish the target, subject to the specific language of the purchase agreement.

Problems often arise when the target is based on one set of accounting practices and the closing calculation is prepared using another. The agreement should address the applicable accounting hierarchy. For example, it may require the use of specifically negotiated principles, consistent historical practices, generally accepted accounting principles, or a stated order of precedence among them. Without clear language, the parties may disagree over reserves, cutoffs, classifications, estimates, and other judgmental balances.

Common Areas of Disagreement

Working capital disputes frequently involve one or more of the following issues:

• Unclear definitions. The agreement does not clearly define the accounts, calculations, or accounting principles used in the adjustment.
• Inconsistent accounting. The closing balance sheet applies policies or estimates differently from those used to determine the target.
• Cutoff errors. Revenue, receivables, inventory, payables, or accrued expenses are recorded in the wrong period around the closing date.
• Classification questions. The parties disagree about whether a balance is operating, financing, debt-like, transaction-related, or otherwise excluded.
• Reserve and estimation differences. Accounts such as doubtful accounts, obsolete inventory, rebates, returns, bonuses, and warranty obligations may require judgment.
• Spreadsheet and formula errors. Large or complex workbooks may contain incorrect signs, broken links, hard-coded amounts, inconsistent ranges, or simple addition and subtraction mistakes.

The Closing-Date Challenge

Purchase agreements often require the buyer to deliver the closing working capital statement within a specified period after closing, commonly 60 to 90 days. The exact deadline varies by agreement. Preparing the calculation can be difficult because the transaction may close in the middle of a month, payroll cycle, billing period, or inventory cycle. The general ledger may not naturally align with the precise closing date.

Both parties should plan for the cutoff before closing. This may include identifying required reports, assigning responsibility for account reconciliations, establishing inventory procedures, documenting estimates, and preserving access to supporting records. Early preparation can improve accuracy and reduce the pressure that often follows a demanding transaction process.

Final Thoughts

The working capital adjustment is more than a mechanical post-closing calculation. It is an important part of the negotiated purchase price. When the target is supportable, the methodology is clearly documented, and the closing calculation is prepared consistently, buyers and sellers are better positioned to complete the adjustment efficiently and avoid unnecessary disputes.

A transaction advisor can assist with historical working capital analysis, target development, purchase agreement schedules, closing calculations, and review of a counterparty’s proposed adjustment. Involving an advisor early can help identify issues while there is still time to address them in the agreement and the closing process. Contact Meaden & Moore’s transaction advisory team for guidance on working capital adjustments and support throughout your transaction.