The Working Capital Adjustment: Why It’s One Of the Most Litigated Post-Closing Provision in M&A
The most negotiated terms in an M&A deal are not the ones most likely to cause problems. The working capital adjustment is.
It is usually treated as a technical afterthought. It shouldn’t be.
By the time a working capital dispute surfaces, the deal has closed, the purchase price has changed hands, and the parties are no longer aligned. At that point, a disagreement over how to calculate working capital is not an accounting question. It is a money question, and it can be a significant one.
Understanding how working capital adjustments work, where they break down, and how to negotiate them carefully is essential for any buyer or seller in a private M&A transaction.
What the Adjustment Is Supposed to Do
When a buyer acquires a business, it expects to receive a going concern: a company with enough working capital to operate normally after closing without requiring an immediate infusion of cash. The working capital adjustment is the mechanism that enforces that expectation.
The mechanics work as follows. During negotiation, the parties agree on a working capital target, sometimes called the peg. The target is typically based on the company’s historical average working capital over a trailing period, often twelve months. At closing, the actual working capital is estimated. After closing, the parties finalize the calculation through a true-up process. If actual working capital at closing is above the target, the purchase price increases. If it is below the target, the purchase price decreases.
In theory, the adjustment is straightforward. In practice, it is the source of more post-closing friction than almost any other deal term.
The Definition of Working Capital Is the Dispute
Working capital is typically defined as current assets minus current liabilities. That definition sounds simple. It is not.
The question of which items are included in current assets and current liabilities, and how each line item is measured, is where post-closing disputes almost always originate. Cash and cash equivalents: included or excluded? Deferred revenue: a current liability or excluded from the calculation entirely? Accrued bonuses: included or treated as a separate seller liability? Customer deposits: current liability or excluded? Income tax receivables and payables: in or out?
Every line item in the working capital definition is a negotiation over value. Not in theory. In dollars.
Because the definition is often drafted at a high level of generality, the parties frequently do not discover that they have different views of what is included until the post-closing true-up is underway.
How to think about it: The working capital definition should be negotiated with the same care as the purchase price itself. The agreement should include an illustrative working capital schedule, prepared using the same accounting principles and line item treatments that will govern the post-closing calculation. If the parties cannot agree on an example calculation before closing, they will not agree on the real one after it.
Setting the Target: The Peg Problem
The working capital target is supposed to reflect the normalized level of working capital the business needs to operate. In practice, agreeing on what “normalized” means is its own negotiation.
Sellers typically want a lower target. A lower peg means the seller is more likely to receive a post-closing upward adjustment, or less likely to face a downward one. Buyers typically want a higher target, for the opposite reason. Both parties will present historical data selectively to support their preferred peg.
Seasonal businesses add another layer of complexity. A company whose working capital fluctuates significantly over the course of a year may have very different working capital at a December closing than it does in August. A trailing twelve-month average may not capture the seasonal pattern accurately, and a buyer closing at a peak working capital period may be receiving less than it bargained for.
How to think about it: If you don’t have a clear methodology for the peg in the agreement, you don’t really have a peg. The target should be derived from a defined methodology, typically a trailing twelve-month average calculated using the same line item definitions that will govern the closing calculation. For seasonal businesses, confirm that the average reflects the expected working capital at the anticipated closing date, not just a calendar average. Get the methodology in the agreement, not just the number.
GAAP Is Not One Answer
Most purchase agreements require the working capital calculation to be prepared in accordance with GAAP, applied consistently with the company’s historical practices. That formulation creates its own set of problems.
GAAP permits a range of acceptable treatments for many line items. A company’s historical practice may have been permissible under GAAP but different from the standard treatment. If the buyer applies strict GAAP to the closing calculation while the seller’s historical practice was a different but equally permissible treatment, the parties have a dispute even though both positions are technically correct.
“Consistently applied” only works if everyone agrees on what consistency means before closing.
How to think about it: If the company has any non-standard accounting treatments, identify them before closing and address them explicitly in the purchase agreement. “GAAP consistently applied with historical practices” is insufficient if the historical practices are not documented. Attach a schedule of specific accounting policies to the agreement if there is any risk of ambiguity.
The Takeaway
The working capital adjustment is not a boilerplate provision. It is a price term, and it deserves the same attention as the headline number. Getting it right requires four things: a definition of working capital that specifies every material line item, an illustrative schedule that demonstrates how the calculation works in practice, a clearly defined peg methodology, and accounting policy documentation sufficient to resolve ambiguity after closing.
None of that is complicated. But it requires the parties to do the work before closing rather than after. By the time a working capital dispute surfaces, the deal is closed and the money has moved. At that point, the working capital adjustment is not a technical exercise. It is a fight over price.
This post is general information only and does not constitute legal advice. For questions about your specific situation, contact Cruxterra Law Group.
