Working Capital Adjustments in M&A
In M&A, the headline price is rarely the final price. Between signing and closing, the target keeps operating: receivables are collected, payables come due, inventory turns, and accruals change. A working capital adjustment exists to account for that movement.
That sounds technical. It is not. In many private deals, the working capital mechanism is one of the biggest drivers of post-closing value transfer. A poorly set peg or vague closing accounts process can move millions between buyer and seller after the SPA is signed.
Buyers who treat working capital as boilerplate risk overpaying for a business that closes undercapitalised. Sellers who leave the peg and accounting methodology until the end of the process risk handing the buyer a post-closing price reduction tool. The issue is simple: the agreed purchase price only matters if it survives the adjustment mechanics.
What Is a Working Capital Adjustment?
A working capital adjustment is a purchase price mechanism that compares actual working capital at closing against an agreed target, or peg.
If actual working capital is above the peg, the purchase price usually increases. If it is below the peg, the seller pays the difference back.
In broad terms, working capital is usually defined as current assets minus current liabilities, excluding cash, debt, and other items handled elsewhere in the purchase price structure. But in real deals, the definition is negotiated line by line. Whether working capital includes deferred revenue, bonus accruals, tax items, warranty provisions, intercompany balances, or prepaid expenses can materially change the economics.
That is why working capital is not just an accounting concept. In an SPA, it is a negotiated pricing mechanism.
Why M&A Deals Need Working Capital Adjustments
The adjustment solves a timing problem. Buyers and sellers agree value before closing, but the business continues trading in the meantime.
Without a working capital adjustment, the seller could deliver a business with less short-term liquidity than the buyer expected. The buyer would then have to inject cash immediately after closing just to support normal operations.
The adjustment also limits manipulation during the interim period. Without it, a seller could improve its own outcome by collecting receivables aggressively, delaying supplier payments, or cutting inventory purchases before closing.
So the mechanism serves two purposes:
- it helps ensure the buyer receives a business with a normal level of operating liquidity;
- it reduces the seller’s ability to shift value out of the business before closing.
What Counts as Working Capital?
This is where many disputes begin. The definition of working capital looks straightforward until the parties start arguing over specific line items.
Typical assets include receivables, inventory, and prepaid expenses. Typical liabilities include payables, accrued expenses, and deferred revenue. But treatment varies by deal and by business model.
For example, in a software deal, deferred revenue can be a major issue. If it is included as a current liability, net working capital falls. If it is excluded, the seller may keep a higher peg and a better purchase price outcome.
In a manufacturing deal, inventory reserves are often the flashpoint. The seller may argue stock is saleable and should remain at cost. The buyer may argue that slow-moving inventory should be written down. That difference flows directly through the adjustment.
These are not side issues. They are price issues.
The Working Capital Peg
The peg is the target amount of working capital the business is expected to have at closing. It is the benchmark for the entire adjustment.
This is often the most important number in the mechanism and one of the least scrutinised. In competitive deals, buyers sometimes accept the seller’s proposed peg too quickly. That can be expensive.
The peg is often based on a historical average, commonly over 12 months. But the choice of period matters. A 6-month, 12-month, or 24-month average can produce very different results, especially in seasonal businesses.
A retailer building inventory before peak season, an agricultural company with post-harvest receivables, or a project business with uneven billing cycles will not have a stable monthly working capital profile. Using the wrong reference period can distort the peg and shift value unfairly.
The peg can also be distorted by sale-process behaviour. If management has tightened collections, deferred payments, or otherwise managed the balance sheet aggressively before signing, the historical average may not reflect normal operations.
A good peg analysis should test:
- multiple lookback periods;
- seasonality;
- unusual events in the reference period;
- line-item movement, not just the net number.
The right peg is not just an average. It is a negotiated view of normal operating needs.
How Completion Accounts Disputes Start
In a completion accounts deal, the purchase price paid at closing is provisional. After closing, the buyer prepares a closing balance sheet and calculates actual working capital. The seller reviews it, disputes specific items if necessary, and unresolved issues go to an independent accountant.
In theory, that is a neutral process. In practice, it is adversarial.
The buyer controls the books after closing and has a direct financial incentive to reduce net working capital. Every extra accrual, reserve increase, write-down, or receivable adjustment can reduce the purchase price payable to the seller.
The seller is then left challenging those numbers from the outside, often with less access and less control than it had before closing.
That is why the SPA has to be precise. If the agreement leaves room for interpretation, the buyer usually gets first shot at the economics.
The Main Sources of Dispute
Inventory
Buyers often challenge inventory value after closing, especially where stock is old, slow-moving, or specialised. Sellers argue the stock is saleable. Buyers argue reserves were understated.
Receivables and revenue recognition
In contract-heavy or service businesses, buyers may say revenue was recognised too early or receivables are overstated. Sellers respond that the historical policy was consistently applied.
Accruals and provisions
Bonus accruals, warranty reserves, rebates, holiday pay, litigation exposure, and similar items often involve judgment. Increasing them lowers working capital and benefits the buyer.
Bad debt reserves
A buyer may claim that ageing receivables were less collectible than the seller assumed. The seller may say the buyer is using hindsight and post-closing collections data to rewrite the closing balance sheet.
Intercompany balances in carve-outs
Carve-out deals are especially difficult because the target’s standalone balance sheet may be partly artificial. Shared costs, group cash management, and allocated liabilities can make “normal” working capital highly debatable.
The Limits of the Independent Accountant Process
Parties often assume the independent accountant solves everything. It does not.
The accountant usually decides only disputed items, not the full closing balance sheet from scratch. Its role is limited by the SPA, and in many cases it is effectively deciding between the parties’ competing positions within a defined range.
That encourages aggressive anchoring. If one side presents a stretched but defensible number, it can widen the potential outcome. The process is still useful, but it works best when the SPA already answers the main methodological questions.
Completion Accounts vs Locked Box
The main alternative to completion accounts is a locked box structure.
In a locked box deal, the purchase price is fixed using a historical balance sheet at a set date before signing. There is no post-closing working capital true-up. Instead, the seller promises that no value has leaked out of the business between the locked box date and closing, other than agreed permitted leakage.
For sellers, the attraction is certainty. For buyers, the trade-off is that they rely more heavily on diligence, leakage protection, and interim covenants.
Locked box removes the closing accounts fight, but it does not remove risk. It simply changes the dispute. Instead of arguing about reserves and accruals, the parties argue about leakage and whether specific payments were permitted.
Why QoE Reports Often Miss the Problem
Buyers often rely on the quality of earnings report to set the peg. That is useful, but not enough.
A QoE is not an audit. It is based largely on the seller’s books, management explanations, and agreed procedures. If the seller has been managing working capital aggressively during the sale process, the QoE may treat that position as normal and build it into the baseline.
That means the peg can end up reflecting a temporary or engineered balance sheet rather than the business’s actual steady-state needs.
A QoE is a starting point. It is not a substitute for an independent working capital analysis.
What Good Drafting Looks Like
The best working capital provisions reduce ambiguity before a dispute starts.
A specimen balance sheet
The SPA should include a worked example showing exactly which line items are included, excluded, and how they are calculated.
A clear accounting hierarchy
The agreement should say what governs in what order:
- the specimen statement and specific methodologies;
- historical accounting policies consistently applied;
- IFRS, UK GAAP, or other relevant standards.
Express treatment of sensitive items
If the parties know deferred revenue, bonuses, warranty reserves, rebates, or intercompany balances are likely to be contentious, the SPA should address them directly.
Tight deadlines
Sellers should push for short timelines for delivery of closing accounts, review, negotiation, and expert referral. Delay usually favours the buyer.
Access rights
The seller needs access to records, work papers, and supporting calculations if it is expected to review and challenge the buyer’s numbers meaningfully.
De minimis or collar thresholds
A tolerance band can reduce fights over immaterial differences and focus the process on meaningful deviations.
What Buyers Should Focus On
Buyers should treat working capital like a core pricing issue, not a back-end accounting exercise.
That means:
- analysing monthly working capital over multiple years;
- understanding movement in receivables, payables, inventory, and accruals separately;
- testing for seasonality;
- identifying any sale-process distortion;
- checking that the legal definition matches the financial model;
- being especially careful in carve-outs and long-gap deals.
What Sellers Should Focus On
Sellers need to prepare for the working capital schedule as seriously as they prepare for warranties and indemnities.
That means:
- modelling the peg under different methodologies;
- understanding which accounts are likely to be challenged;
- documenting historical accounting treatment;
- negotiating exclusions where appropriate;
- preserving evidence that supports the seller’s position in a future dispute.
Every vague line item in the SPA is a future argument waiting to happen.
Why Working Capital Matters More Than Most People Think
Working capital adjustments do not usually make headlines, but they routinely decide where value ends up after closing.
The real purchase price is not the headline enterprise value. It is the number left after debt, cash, debt-like items, transaction expenses, escrows, and working capital adjustments have all been applied.
That is why the mechanism matters. A weak peg, vague drafting, or poorly controlled closing accounts process can transfer millions after the deal is supposedly done.
Working capital is part of the price.
