Working Capital Adjustments in M&A
In October 2019, Forescout Technologies agreed to sell itself to private equity firm Advent International for $1.9 billion. By the time the pandemic had rearranged the world five months later, Advent wanted out. The mechanism it reached for was not a material adverse effect clause — the obvious exit ramp when the world is ending — but a claim that Forescout had failed to maintain its business in the ordinary course, including, critically, that working capital had deteriorated. The ensuing litigation laid bare a truth that every dealmaker knows but few discuss openly: the working capital adjustment is not a rounding error at the back of the purchase agreement. It is, in many transactions, the most commercially significant post-signing negotiation that takes place — and the one for which both sides are least prepared.
Working capital adjustments are the single most litigated post-closing economic issue in M&A, and the frequency of disputes is rising even as deal documentation gets longer. The reason is structural: the adjustment mechanism sits at the intersection of accounting judgement, commercial incentive, and information asymmetry, and no amount of drafting can eliminate those tensions entirely.
Buyers who treat the working capital provisions as boilerplate are leaving money on the table. Sellers who ignore the target peg until the final round of negotiations are handing their counterparty a loaded weapon. Understanding the mechanics — and where they break down — is not optional for anyone involved in acquiring or disposing of businesses.
What Are Working Capital Adjustments and Why Do M&A Deals Need Them?
Every acquisition has a timing problem. The buyer and seller agree on a headline enterprise value weeks or months before the deal closes. But the business does not stop operating during that interval. Customers pay invoices, suppliers demand payment, inventory moves in and out of warehouses, employees accrue holiday pay. By the time the shares actually change hands, the cash flowing through the balance sheet may look nothing like what either party contemplated when they shook hands on the price.
The working capital adjustment solves this by establishing a normal level of net working capital — typically defined as current assets minus current liabilities, excluding cash and debt-like items — and then adjusting the purchase price at closing (or shortly after) to reflect any deviation from that norm. If the business closes with more working capital than the target, the buyer pays a top-up. If it closes with less, the seller gives money back.
In principle, this is elegant. In practice, it is a minefield.
The adjustment is doing two things simultaneously, and this is where most confusion originates.
First, it is a bridge mechanism, ensuring the buyer receives a business with enough short-term liquidity to operate from day one without injecting additional capital.
Second, it is an anti-manipulation device, preventing the seller from stripping cash out of the business between signing and closing by, say, aggressively collecting receivables, delaying inventory purchases, or accelerating payables.
These two functions can pull in opposite directions, and how the mechanism is calibrated determines who bears the economic consequences.
How to Set the Working Capital Target Peg
The target working capital figure — sometimes called the peg or the normal working capital amount — is the most consequential number in the adjustment mechanism, and it is often the least scrutinised. In competitive auctions, sellers frequently propose the target in their draft share purchase agreement and buyers, eager not to rock the boat before exclusivity is granted, accept it with minimal pushback. This is a mistake that can cost millions.
The target is typically derived from the trailing twelve-month average of net working capital, though six-month and twenty-four-month averages are common, and some deals use a point-in-time estimate instead.
The choice of lookback period is not neutral. A business with seasonal working capital cycles — a retailer building inventory ahead of Christmas, an agricultural company whose receivables spike after harvest — will produce very different targets depending on whether you average across the full cycle or cherry-pick the months. A seller with a strong financial controller will propose the lookback period that produces the highest target, knowing this minimises the risk of a post-closing clawback.
The composition of the target matters as much as the number. The definition of working capital in any given SPA will include or exclude specific line items — prepaid expenses, deferred revenue, accrued bonuses, tax receivables, warranty provisions, intercompany balances — and each inclusion or exclusion moves money between buyer and seller.
Example: A software company with £40 million in annual recurring revenue is being sold for 8x ARR, or £320 million. Its balance sheet shows £12 million in net working capital on a trailing twelve-month average basis. But £3 million of that is deferred revenue — cash collected from customers for subscriptions not yet delivered. If deferred revenue is included in the working capital definition (as a current liability), the target drops to £9 million. If it is excluded, it stays at £12 million. That £3 million swing is nearly 1% of the headline price, and in a deal with a 10% equity rollover structure, it could represent 10% of the seller's upfront cash proceeds.
Completion Accounts Disputes: How Post-Closing Adjustments Go Wrong
If the target is where the money is set up, the closing accounts process is where it is fought over. The standard mechanism works like this: within 60 to 90 days of closing, the buyer (who now controls the books) prepares a closing balance sheet and calculates actual net working capital. The seller reviews it, objects to specific line items, and the two sides negotiate. If they cannot agree, the disputed items go to an independent accountant whose determination is final and binding.
The buyer prepares the closing balance sheet with full knowledge that every dollar of additional accrual, every reserve that can be topped up, and every receivable that can be written down will reduce the working capital figure and generate a payment from the seller. The incentives are as nakedly adversarial as anything in corporate finance. Buyers routinely book post-closing true-up adjustments that they frame as corrections to the seller's accounting but which, viewed from the other side of the table, look like retroactive price reductions.
The most common battlegrounds include:
Inventory valuation
The seller carried inventory at cost. The buyer, now in possession of the business and its customer pipeline, writes down a tranche of slow-moving stock that the seller would argue was perfectly saleable. A manufacturing business with £8 million in inventory might see £500,000 to £1 million of write-downs in the first closing balance sheet, every penny of which flows through the working capital adjustment.
Revenue recognition timing
The seller recognised revenue on certain contracts at completion. The buyer argues the accounting policy should have used percentage-of-completion, or that certain milestones were not genuinely achieved before closing. In service businesses, this single issue can dwarf all other working capital disputes combined.
Accruals and provisions
The seller ran lean provisions for warranty claims, litigation reserves, and employee bonuses. The buyer, armed with hindsight and a fresh set of auditors, determines that those provisions were inadequate. Each incremental accrual reduces working capital and shifts value from seller to buyer.
Intercompany balances
In carve-out transactions — where the target is being extracted from a larger group — the allocation of shared costs, transfer pricing adjustments, and intercompany receivables and payables can be genuinely ambiguous. A carve-out balance sheet is, to some extent, a work of fiction: it represents what the business's financials would have looked like had it been standalone, and reasonable people can disagree violently about the assumptions that underpin that hypothetical.
The independent accountant process, which is supposed to serve as a neutral tie-breaker, has its own problems. Most SPAs limit the accountant to choosing a figure within the range bounded by the buyer's and seller's positions — a baseball arbitration model that encourages both sides to anchor aggressively. The accountant cannot award more than the buyer's figure or less than the seller's figure on any individual line item, which creates game-theoretic incentives to include marginal claims in the hope that the accountant will split differences.
Locked Box vs Completion Accounts: Which Mechanism Protects Value?
Partly in response to the dysfunction of completion accounts, the locked box mechanism has gained significant market share, particularly in European transactions and private equity exits. In a locked box deal, the parties agree on a balance sheet at a fixed date before signing — the locked box date — and the purchase price is set by reference to that balance sheet. There is no post-closing adjustment. Instead, the seller gives a covenant that no value has leaked from the business between the locked box date and closing (through dividends, management fees, intercompany transfers, or other leakage events), and the buyer typically receives a per diem interest payment on the purchase price to compensate for the economic exposure during the gap period.
The locked box shifts risk from the buyer to the seller, because the buyer is paying a price derived from a historical balance sheet and must trust that the business has been operated normally since that date. In volatile industries, or where the signing-to-closing gap is long (common in deals requiring regulatory approval), this can be a significant exposure. But it eliminates the adversarial closing accounts process entirely, and for many sellers — particularly private equity funds exiting portfolio companies — the certainty of avoiding a multi-million-pound working capital dispute is worth the trade-off.
The locked box does not eliminate disputes — it merely relocates them. Instead of arguing about closing accounts, the parties argue about what constitutes leakage and whether specific payments fall within the "permitted leakage" carve-outs agreed at signing. A bonus payment to a key employee? Permitted if it was in the ordinary course. A dividend declared but not yet paid? Leakage, unless specifically carved out. The litigation may be simpler, but it is no less commercially significant.
Why Quality of Earnings Reports Miss Working Capital Manipulation
There is a deeper problem that neither completion accounts nor the locked box can solve, and it goes to the heart of why working capital disputes are so persistent.
In most M&A transactions, the buyer commissions a quality of earnings (QoE) report from an accounting firm during due diligence. The QoE analyses the target's historical earnings, normalises them for one-off items, and critically produces an estimate of normalised working capital. This estimate often becomes the basis for the target peg in the SPA.
But the QoE has a structural limitation. It is prepared based on the seller's books, the seller's accounting policies, and the seller's management representations. The QoE provider does not audit the financials — they perform agreed-upon procedures which, despite the impressive-sounding name, amount to a limited review with significant reliance on management's explanations. If the seller's controller has been managing working capital aggressively — accelerating receivables collections in the months leading up to the sale process, deferring payable payments, building up inventory to smooth production ahead of the transaction — these actions will be reflected in the trailing average as if they were normal. The QoE will bake the manipulation into the baseline.
Negotiating Working Capital Provisions: What Best Practice Looks Like
The best-negotiated working capital provisions share several features that reduce — though never eliminate — the risk of post-closing disputes.
A detailed worked example
Rather than defining working capital in the abstract and hoping both sides' accountants agree on what that means, the SPA includes a specimen balance sheet showing exactly which line items are included, which are excluded, and how each is calculated. This specimen becomes the interpretive anchor for the closing accounts. Disputes over line item classification drop materially when both parties have negotiated over a specimen during the deal.
Consistent accounting policies with teeth
The SPA should specify not just that the closing balance sheet will be prepared in accordance with the target's historical accounting policies, but which specific policies apply to each material line item. IFRS as applied by the company is not precise enough when the company has exercised judgement on revenue recognition timing, inventory reserves, or bad debt provisioning. The strongest provisions reference the specific policies by name and include a hierarchy: first, the specific methodology in the specimen; second, the company's historical accounting policies as consistently applied during the reference period; third, IFRS or UK GAAP as applicable.
A collar or de minimis threshold
Many deals include a tolerance band around the target — typically 1-2% of the peg — within which no adjustment is made. This eliminates disputes over immaterial amounts and reduces the incentive for the buyer to staff an army of accountants on the closing balance sheet review. A £200,000 collar on a deal with a £10 million working capital target means the parties are only arguing about genuine deviations from the norm, not rounding differences.
Time-limited dispute windows
The seller should insist on tight deadlines for the buyer to deliver the closing balance sheet (60 days, not 90 or 120) and for the dispute resolution process to conclude (30-45 days of negotiation, then 30 days for the independent accountant). Drawn-out working capital disputes favour the buyer, who controls the books and can use the passage of time to create facts on the ground — write-downs, policy changes, and reserve adjustments that become harder to unwind as the months pass.
Working Capital Due Diligence: A Checklist for Buyers and Sellers
For anyone negotiating a deal with a completion accounts mechanism, here is what to prioritise:
The target peg deserves as much attention as the headline multiple. Run the trailing average over multiple lookback periods — six, twelve, eighteen, and twenty-four months — and understand why they differ. If the seller is proposing a twelve-month average that is materially higher than the twenty-four-month average, ask what happened in the trailing twelve months and whether it is repeatable.
Examine the working capital composition at the line-item level, not just the net figure. A business can have a stable net working capital figure while individual components are moving in opposite directions — receivables growing because collections are slowing, offset by payables stretching because the company is paying suppliers late. The net number looks fine; the underlying dynamics are deteriorating.
For sellers: negotiate the specimen balance sheet as aggressively as you negotiate the warranties. Every line item you allow into the working capital definition is a line item the buyer will scrutinise — and potentially challenge — in the closing accounts. Where you have discretion to exclude items (tax assets and liabilities, non-trade accruals, intercompany balances), exercise it.
For buyers: invest in the independent working capital analysis before you agree the target. The QoE is a starting point, not a conclusion. The additional cost of having your own finance team build a bottom-up working capital model — with seasonality adjustments, trend analysis, and scenario work on how the components might behave between signing and closing — will pay for itself many times over if the deal proceeds.
Watch the gap between signing and closing. The longer the interim period, the more opportunity for working capital to drift from the target, and the greater the risk of a dispute. In deals requiring antitrust clearance from multiple jurisdictions — where six to twelve months between signing and closing is not uncommon — the working capital provisions need to be robust enough to handle a full seasonal cycle, not just a quarter.
The True M&A Purchase Price: Why Working Capital Adjustments Matter More Than the Headline
Working capital adjustments are not glamorous. They do not make headlines, they rarely feature in case studies at business schools, and even experienced M&A lawyers sometimes treat the working capital schedule as something to delegate to the junior associate and the auditors. That is precisely why they remain one of the most reliable sources of post-closing value transfer in private M&A.
Every deal professional will tell you that the purchase price is the most important number in a transaction. They are wrong. The most important number is the purchase price after the working capital adjustment, the debt-like items have been netted off, and the escrow has been released. The distance between the first number and the second is where working capital adjustments live — and where the real negotiation happens.
