At its core, working capital refers to the short-term assets and liabilities that keep a business running—things like cash, accounts receivable, inventory, and accounts payable. The working capital adjustment is a negotiation between the buyer and seller about how much of this operational capital should remain in the business after the sale.

 

The goal? Ensure the business has enough liquidity to operate effectively without requiring the buyer to inject additional funds immediately after the deal closes.

 

Why Working Capital Matters

 

Imagine buying a car with an empty gas tank. Sure, the car may have all the features you wanted, but without gas, it’s not going anywhere. The same principle applies to working capital in a business. Without enough liquidity to pay bills, manage inventory, and handle day-to-day expenses, the business stalls.

 

For buyers, the working capital adjustment protects against unexpected cash shortfalls. For sellers, it ensures they’re not leaving more cash in the business than necessary. Striking the right balance is critical for a successful transition.

 

How to Approach the Working Capital Adjustment

 

1. Understand the Baseline

 

The first step is to determine the business’s historical working capital levels. This involves reviewing the company’s financials over the past 12–24 months to identify average working capital requirements.

 

Key metrics to evaluate include:

• Accounts Receivable Turnover: How quickly the business collects payments from customers.
• Inventory Turnover: How efficiently inventory is managed and sold.
• Accounts Payable Turnover: How promptly the business pays its suppliers.

 

The baseline serves as a starting point for negotiations, ensuring the agreed-upon working capital is based on historical performance rather than arbitrary figures.

 

2. Anticipate Seasonal Fluctuations

 

Some businesses experience seasonal shifts that impact working capital. For example, a retail company may require more working capital before the holiday season to stock inventory, while a landscaping business might have higher needs during the summer months.

 

Adjusting for seasonality ensures the working capital left in the business aligns with operational demands during peak periods.

 

3. Negotiate the Target Working Capital

 

The target working capital is the agreed-upon amount that will remain in the business at closing. This figure often becomes a key point of negotiation between the buyer and seller.

 

Sellers may aim for a lower target to maximize their cash proceeds, while buyers may push for a higher target to reduce their financial risk. A fair compromise requires clear communication, transparency, and an understanding of the business’s operational needs.

 

4. Incorporate Working Capital into the Purchase Agreement

Once the target working capital is determined, it should be documented in the purchase agreement. This ensures both parties are aligned and prevents disputes post-closing.

 

Key elements to include:

• Definition of Working Capital: Clearly outline what is included (e.g., cash, receivables, inventory) and excluded (e.g., long-term debt).
• Adjustment Mechanism: Specify how adjustments will be handled if actual working capital at closing differs from the target. For example, if the working capital is lower than agreed, the seller may owe a refund to the buyer.

5. Plan for Post-Closing Adjustments

 

Even with the best planning, working capital at closing may differ slightly from projections. Post-closing adjustments allow for reconciliation, ensuring the buyer and seller are fairly compensated.

 

Buyers should conduct a detailed review of the working capital shortly after closing, comparing actual figures to the target. Any discrepancies should be addressed promptly to maintain goodwill between the parties.

 

Practical Advice for Buyers and Sellers

• For Buyers: Approach working capital negotiations with a focus on what the business needs to operate effectively. Avoid pushing for unrealistically high targets that could derail the deal or create unnecessary tension.
• For Sellers: Be transparent about historical working capital levels and any factors that may impact future needs. This builds trust and reduces the risk of post-closing disputes.
• For Both Parties: Engage experienced advisors who understand working capital adjustments. Their expertise can help navigate complex negotiations and ensure the final agreement benefits both sides.

 

Closing Parable: The Relay Team

 

Picture a relay race. The runner in the first leg starts strong, building momentum and creating a lead. As they approach the handoff, they slow just enough to pass the baton smoothly to the next runner. If the handoff is too slow or the baton drops, the team loses precious time, and the race may be lost.

 

In a business acquisition, the working capital adjustment is that baton. A smooth handoff ensures the buyer can maintain the business’s momentum, while the seller can exit confidently, knowing they’ve left the new owner in a strong position.

 

But if the working capital isn’t carefully negotiated—if the baton is dropped—the transition can falter, leaving both parties scrambling to recover. The lesson? Take the time to plan, negotiate, and execute a seamless handoff. It’s not just about winning the deal—it’s about setting the stage for lasting success.

 

Final Thoughts

 

The working capital adjustment may seem like a technical detail in the broader scope of a business acquisition, but its impact is profound. By ensuring the business has the liquidity needed to operate post-closing, both buyers and sellers can protect their interests and pave the way for a successful transition.

 

As you navigate this process, remember to prioritize transparency, rely on historical data, and engage experienced advisors. A well-negotiated working capital adjustment isn’t just a line item—it’s the foundation for the next chapter of the business’s journey.