This adjustment ensures that the vendor is fairly compensated for excess or deficit working capital, relative to its normal operating levels, between completion of financial due diligence, signing the Sale and Purchase Agreement (SPA) and the transaction closing date. The objective of a working capital adjustment is to ensure the business maintains adequate short-term operational funding at the time of ownership transfer, preserving its financial stability and safeguarding both parties' interests. 

What is net working capital?

Working capital is generally referred to as the difference between a business’ current operating assets and current liabilities. It is a key liquidity indicator and measure of operating efficiency. In a cash-free, debt-free transaction, net working capital (NWC) represents the amount of short-term operational funding required to carry on with daily revenue-generating activities.

How a working capital adjustment works in practice

In a typical M&A transaction, the purchase agreement includes an NWC adjustment mechanism to ensure that any deviation from the agreed Target (or Peg) NWC at closing is reflected in the final purchase price. If the actual NWC at closing exceeds the Target NWC, the purchase price increases because the buyer is receiving more short-term assets (e.g., inventory, receivables) than expected. Conversely, if actual NWC is lower than the Target NWC, the purchase price is reduced to reflect the shortfall.

While the NWC adjustment mechanism is designed to ensure fairness, it is often one of the most contentious elements in M&A negotiations, as it directly impacts the purchase price on a dollar-for-dollar basis. Depending on the industry and business model, NWC can represent a significant proportion of the transaction value, sometimes reaching up to 20%.

This adjustment mechanism is important because purchase prices are generally determined based on historical financial data, assuming the business operates at a “normal” level at closing. However, closing often occurs months after financial due diligence and signing the SPA. The actual NWC at that time may differ significantly from the assumed “normal” level.

From a conceptual standpoint, NWC adjustments ensure that the buyer receives a business with sufficient liquidity to avoid unexpected post-closing cash injections, and that the seller is fairly compensated for excess working capital. While changes in NWC affect cash flow, they primarily serve to align the final purchase price with the agreed valuation assumptions.

Beyond pricing adjustments, the NWC adjustment mechanism serves as an additional layer of financial verification for the buyer, supplementing due diligence efforts. It can crystalise issues such as uncollectable receivables, slow-moving inventory or accounting misstatements that were not fully addressed during pre-acquisition analysis.

Proactively planning for NWC adjustments helps sellers avoid transferring excess working capital without compensation, particularly during peak business cycles, while protecting buyers from unexpected cash shortages post-acquisition.

Common contentions in NWC adjustments

Misunderstanding the purpose of the adjustment

A common misconception is that NWC adjustments are merely an attempt to manipulate the purchase price. However, when both parties understand the underlying rationale i.e. ensuring the buyer acquires the business with a sustainable level of working capital in line with its valuation, disputes tend to subside.

If historical financial data reliably reflects expected NWC fluctuations, adjustments may be minimised, though they are often necessary due to seasonality or business cycle changes.

Misunderstanding the mechanism can lead to attempts at short-term working capital manipulation. For example, a seller might accelerate billing or shipments before closing to inflate receivables or delay supplier purchase orders to artificially reduce liabilities. While covenants typically restrict outright manipulation, grey areas remain, potentially leading to disputes.

Insufficient communication

Many NWC issues arise due to inadequate communication. If the seller does not provide sufficient data to establish a reasonable Target NWC, the buyer may default to proposing a Target NWC based on the highest observed historical levels, erring on the side of caution. This can frustrate the seller, potentially stalling the transaction and leading to prolonged negotiations and increased legal costs.

Some disputes arise over the definition of NWC and the accounting policies applied to specific working capital components. For example, if “net working capital” is not clearly defined, parties may disagree on whether to include or exclude certain items, such as deferred revenue, customer deposits or prepaid expenses. Clarity in the contract is paramount. The SPA should explicitly define the working capital components, reference trial balance account codes, specify inclusions and exclusions, and outline the methodology applied.

Buyers and sellers may interpret accounting principles differently, leading to post-closing disputes. A common area of contention arises when the agreement states that calculations must follow generally accepted accounting principles (GAAP) consistent with past practice, yet post-closing, the buyer applies stricter accounting standards than the seller historically did.

For example, the seller may not have recorded a bad debt provision for accounts receivable or an obsolescence provision for slow-moving inventory, while the buyer insists on recognising these adjustments. This reduces the closing NWC (as receivables and inventory are recorded net of provisions), ultimately decreasing the purchase price, even though the business operations remain unchanged.

These discrepancies between GAAP interpretations and historical accounting practices are among the most frequent causes of post-closing disputes.

Failure to account for seasonality in NWC

Seasonality is a critical factor in determining an appropriate Target NWC, particularly for businesses with cyclical working capital patterns. Below are some examples of NWC changes in seasonal businesses:

• Retailers ramp up inventory before peak shopping seasons.
• Construction companies carry high receivables when large one-off projects are in progress.
• Agricultural businesses require less working capital during dormant months.
• Mining equipment distributors may stockpile inventory in line with multi-year mining industry cycles.

If closing occurs during a peak season, NWC may be inflated due to higher inventory and receivables. Conversely, an off-season closing may result in a lower NWC, which does not reflect the business’s typical operating cycle. To ensure fairness, assessment of the Target NWC should consider historical patterns and the business’ growth trajectory, such as:

• Last Twelve Months (LTM) and/or rolling averages.
• Multi-year adjusted benchmarks.
• One-off events resulting in abnormal spikes or drops should be excluded to prevent skewing the Target NWC.
• Where revenue is trending upward, growth adjustments should be considered to reflect the scale of operations as of closing rather than relying on a stale average.

Conclusion

Disputes over NWC adjustments can be time-consuming and costly, potentially souring an otherwise successful transaction. Therefore, both buyers and sellers have a strong incentive to carefully negotiate the NWC clause upfront, especially for cyclical businesses. By ensuring transparency in NWC calculations and adjustments early in the deal process, both parties can mitigate post-closing challenges and reduce the risk of disputes.

At Baker Tilly Staples Rodway, our M&A experts specialise in insights-driven financial due diligence and transaction advisory. Contact us today if you need help with effective NWC adjustment mechanisms that promote fairness and mitigate risks in your next M&A transaction.