Working Capital Is the Deal You're Not Watching Closely Enough

Most buyers spend time negotiating purchase price. They model multiples, conduct QofE, Engage in due diligence and negotiate the terms of the deal. But unsophisticated buyers overlook working capital time and time again.

That's the mistake.

Working capital is the operating fuel that keeps the business running between the day you take ownership and the day your first accounts receivable cycle comes in. Failing to take into consideration working capital and how much cash flow you actually need can leave you as a buyer in a position where on paper the business is profitable but you don't actually have the cash to make payroll.

Buyers don't realize how much room there is in the definition. Generally, we defined Working capital as current assets minus current liabilities.

On paper, that sounds simple. It isn't. Which current assets? Which liabilities? Measured over what period? These questions are where real money gets made and lost.

What "Current Assets Minus Current Liabilities" Actually Means in Practice

The textbook definition is clean. Where we find most buyers get into trouble is that in actuality, effectuating the definition is not always as clear.

In order to really break this down let's start from the very top. What are current assets and current liabilities, broadly speaking? Current assets can include cash, accounts receivable, and inventory. Current liabilities typically include accounts payable and accrued expenses. 

Sellers have strong opinions about which items belong in the calculation. A seller who knows their AR balance runs high in Q4 will push hard to include Q4 AR in the peg. A seller carrying unusual accrued expenses at close will push to exclude those. Every carve-out benefits someone. 

The Peg Period: Why 30, 60, and 90 Days Are Not the Same Number

The working capital peg is the target amount the seller is obligated to deliver at close. It's set by looking at historical working capital over a reference period. The question is: which period?

A 30-day trailing average reflects the most recent month. A 90-day average smooths out seasonal swings. For a business with cyclical inventory or seasonal AR, those two numbers can differ by hundreds of thousands of dollars.

Sellers know this. A business that runs lean on inventory in Q1 but heavy in Q4 will look very different depending on which months anchor the peg. Make sure the reference period reflects the ongoing operating needs of the business, not the window that happens to produce the number most favorable to the seller.

What Sellers Try to Move Off the Balance Sheet

This is where the real negotiation happens.

Sophisticated sellers will push to exclude certain items from the working capital calculation: intercompany receivables, certain prepaids, cash earmarked for a specific purpose. Each exclusion reduces what they're obligated to deliver at close, and each one transfers risk to you.

The flip side: sellers will sometimes argue to include items in current assets that inflate the calculation in their favor. Disputed receivables. Aged inventory that hasn't moved in 18 months. Prepaid expenses tied to contracts that won't survive the change of ownership. Know exactly what you're counting before you sign anything.

The Real Takeaway

Working capital is not a back-of-the-envelope calculation you finalize in the 11th-hour review. It is a negotiated definition that determines how much operational runway you have on day one.

At the end of the day working capital isn't something that should be pushed to the wayside. Instead buyers should be factoring in the working capital calculation early on in the transaction, negotiating it with a seller in order to ensure that the company is going to be solvent immediately post-close.

If I'm going to ask you to take away one thing from today, it's going to be this:

1. Negotiate working capital early.
2. Make sure that we define every term and that there is no ambiguity so that a seller doesn't come back and try to argue that certain assets are not included on the balance.
3. Ask yourself why, if a seller is pushing to exclude an asset or a liability, why they are asking for that? To really dig deeper and understand what might be amiss.

At the end of the day remember the purchase price is going to get you the business but the working capital peg is going to be the linchpin in ensuring that you have enough cash in the business in order to operate immediately post-close so that you have the next success story in ETA

Until next time,

Josh