Full Definition
The working capital adjustment is one of the most negotiated and frequently disputed components of M&A purchase agreements. Buyers and sellers agree on a target working capital level—typically the normalized average working capital based on trailing 12 months—that the seller must deliver at close. If actual closing working capital exceeds the target, the purchase price increases dollar-for-dollar; if it falls short, the price decreases. This mechanism ensures sellers cannot manipulate the business to drain working capital (accelerating collections, deferring payables) before closing, leaving the buyer with a working capital deficit immediately post-transaction. Calculating the target requires significant precision in defining working capital components. The purchase agreement must specifically enumerate what is included in current assets and current liabilities for purposes of the calculation, since ambiguity is the primary source of post-close disputes. Common contested items include: whether certain long-term deferred revenue components should be classified as current, how to treat customer deposits, whether accrued bonuses should be included or excluded, and how to handle tax-related items. Legal counsel and financial advisors should draft the definition with extreme precision, as each ambiguous item can become a six- or seven-figure dispute post-close. Post-closing working capital disputes are among the most common sources of M&A litigation. Industry data suggests that 60-70% of M&A transactions involve some form of post-closing purchase price dispute, with working capital adjustments being the most frequent trigger. Most purchase agreements specify a dispute resolution process—typically 30-60 days for the parties to negotiate, followed by submission to an independent accounting firm acting as arbitrator (not a court), who issues a binding determination. Selecting a clearly defined methodology before signing and conducting thorough closing-date estimates reduces but rarely eliminates post-close adjustment disputes.
FAQs
How is the working capital target typically set?
The target is usually set at the LTM average working capital (sum of each month-end balance divided by 12), calculated using the agreed definition of working capital components. This approach normalizes for seasonality and prevents either party from benefiting from timing anomalies. Sometimes a minimum or peg is set at a specific historical balance rather than the average, depending on business seasonality and negotiating leverage.
Can the working capital adjustment benefit the seller?
Yes. If actual closing working capital exceeds the target, the seller receives additional consideration. This occurs when the seller delivers more current assets than expected—higher receivables, more inventory, or lower payables than the normalized level. However, sellers often manage working capital downward before close to minimize the target without triggering a negative adjustment, making actual excess working capital at close less common.
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