Working Capital in Business Acquisitions: The Number Most Buyers Underestimate
Working capital is current assets minus current liabilities — the operating cash the business needs to function from day to day. In an acquisition context, it becomes the subject of a negotiated adjustment at closing: the buyer expects to receive the business with enough working capital to keep operating, and the purchase agreement defines exactly how much that should be.
The Working Capital Formula
Working Capital = Current Assets − Current Liabilities
Current assets typically included: accounts receivable, inventory, prepaid expenses.
Current liabilities typically included: accounts payable, accrued liabilities, deferred revenue.
Exclusions (usually): cash (seller takes it), long-term debt (separate line item), income taxes payable.
The Working Capital Peg
The "peg" is a target amount of net working capital that the buyer and seller agree the business should have at closing. It's calculated as the trailing average — typically 12 months — of the business's actual working capital, which represents normal operating needs.
At closing, the actual working capital is measured and compared to the peg:
- If actual WC is below the peg: the seller owes the buyer the difference (a dollar-for-dollar adjustment to the purchase price)
- If actual WC is above the peg: the buyer pays the seller the excess
- Within a defined range (the "collar"): no adjustment is made
Why Working Capital Matters
A buyer who takes possession of a business without adequate working capital immediately faces a cash crunch: payroll is due, vendors need payment, but the receivables haven't come in yet. Without operating cash, they may need to inject capital they hadn't budgeted for — effectively paying more than the agreed purchase price.
Sellers who drain cash, slow payables, or accelerate receivable collections before closing can artificially depress working capital at measurement date. This is a form of value extraction that buyers should watch for in the weeks before closing.
Example: Working Capital Adjustment in Practice
A distribution business is acquired for $2,000,000. The working capital peg is set at $250,000 based on a 12-month trailing average. At closing, actual working capital is measured at $190,000.
The shortfall: $250,000 − $190,000 = $60,000.
The seller owes the buyer $60,000 — often deducted from a holdback or escrow established at closing for this purpose.
Seasonality Makes This Complicated
For seasonal businesses (landscaping, retail, HVAC), working capital swings dramatically across the year. A landscaping company might have $400K in working capital in June and $80K in January. If the deal closes in January and the peg was based on a June average, the buyer could demand a significant payment from the seller.
The solution is to define the peg carefully — using multiple years of data, specifying the measurement methodology, and sometimes using a different averaging period for highly seasonal businesses.
Related Terms
- Due diligence — when working capital analysis happens
- Deal stack — working capital needs affect total capital required at closing
- SBA 7(a) loan — SBA loans can include working capital in the financed amount
Sources & Further Reading
- SBA: Buying an Existing Business — acquisition process and financing