What Is a Working Capital Adjustment in an M&A Transaction?
What Is a Working Capital Adjustment in an M&A Transaction?
A buyer normally expects to acquire an operating business with enough working capital to continue trading in the ordinary course immediately after completion. A working capital adjustment is one mechanism used to protect that expectation and determine the final purchase price.
Why is working capital included in an M&A purchase-price mechanism?
A company requires operating liquidity to run its normal business. Receivables, inventory, payables and accrued operating liabilities can move materially from month to month, especially in seasonal or fast-growing businesses. If those balances are unusually low or high on the closing date, the economics transferred to the buyer may differ from what was assumed when the enterprise value was agreed.
A working capital adjustment is designed to compare the actual closing position with a normalized level of working capital that reflects ordinary operations. The difference can then increase or decrease the final equity purchase price.
What is a working capital target or “peg”?
The target, often called a working capital peg, is the agreed benchmark against which closing working capital is measured. It is usually informed by historical monthly or seasonal working-capital trends, the company’s operating cycle and the specific definitions negotiated between buyer and seller.
Setting the peg is not simply a matter of taking the latest balance-sheet number. A business with strong seasonality may need a different approach from one with stable monthly operations. Significant growth, changes in supplier terms or customer payment behaviour can also affect what is considered normal.
Which accounts are normally included?
The exact components are determined by the transaction documents. Operating receivables, inventory and trade payables are common starting points, together with agreed operating accruals. Cash, bank debt and other financing balances are typically dealt with separately through the net-debt adjustment rather than being included in working capital.
Clear definitions are essential because the same account should not be counted twice. A liability treated as debt-like should generally not also reduce working capital unless the transaction agreement specifically provides for that treatment.
How does a working capital adjustment affect the purchase price?
Assume the parties agree that normal working capital should be ₹12 crore. If closing working capital is ₹15 crore, the seller may be entitled to an upward adjustment of ₹3 crore, depending on the agreed mechanism. If closing working capital is only ₹9 crore, the purchase price may be reduced by ₹3 crore.
The commercial principle is that the buyer should receive the level of operating working capital that was assumed when pricing the business, while the seller should receive value for any agreed excess delivered at closing.
Why can working capital adjustments become contentious?
The arithmetic is usually straightforward; the definitions are not. Disputes can arise over whether an item is operating or financing in nature, whether a balance is collectible, how inventory should be valued, how provisions are treated, or whether accounting policies have been applied consistently.
Transaction documents therefore need to define both the included accounts and the accounting hierarchy used to prepare the completion accounts. This is one reason why early Transaction Due Diligence can materially improve transaction readiness.
How should a seller prepare before entering an M&A process?
Useful preparation includes:
- monthly working-capital analysis for an appropriate historical period;
- clear reconciliation of receivables, inventory and payables;
- identification of seasonality and unusual month-end movements;
- review of overdue or potentially uncollectible receivables;
- analysis of slow-moving or obsolete inventory;
- separation of operating liabilities from debt-like items; and
- a seller-side view of the appropriate normalized working-capital target.
Doing this before buyer diligence begins can help management understand how much of the headline enterprise value may ultimately convert into equity value and where the main negotiation points are likely to arise.
How does working capital fit into the broader purchase-price bridge?
In many transactions, the final equity value is derived from enterprise value after considering net debt, working-capital adjustments and other agreed items. These mechanisms are interconnected, so definitions should be reviewed together rather than in isolation.
Terex Ventures supports business owners through its M&A & Strategic Transactions Advisory capability, including transaction preparation, valuation analysis and coordination around financial diligence and deal readiness.
Business owners considering an exit may also review how a business owner should prepare to sell a company.
Frequently asked questions
Is working capital the same as cash?
No. Working capital generally focuses on operating current assets and liabilities. Cash and financing debt are usually treated separately in an M&A purchase-price bridge.
Who determines the working capital peg?
The buyer and seller negotiate the target, typically using historical financial information, seasonality, due diligence findings and the specific economics of the business.
Can the working capital adjustment increase the seller’s proceeds?
Yes. If closing working capital exceeds the agreed target and the transaction mechanism provides for a positive adjustment, the final purchase price may increase.
When is the final adjustment calculated?
That depends on the transaction mechanism. In a completion-accounts structure, the final calculation is commonly prepared after closing using balances measured at the closing date and then settled through a purchase-price true-up.
Preparing for a business sale or acquisition?
Terex Ventures supports transaction readiness, valuation analysis, diligence preparation and strategic M&A processes for growth-stage companies and business owners.