There is a number in every business acquisition that gets less attention than it deserves, and that overshadowing has cost buyers and sellers alike significant amounts of money at closing. That number is working capital — the net current assets needed to fund the day-to-day operations of the business between the time it takes in revenue and the time it pays its bills. Working capital sounds like an accounting concept, but in the context of a business acquisition, it is a deal-structure and cash-flow concept with very real financial consequences. Buyers who do not understand working capital typically discover its importance at closing, when they are surprised by a post-closing adjustment that they did not see coming. Sellers who understand it can use it to their advantage — or get caught in manipulation that sophisticated buyers will detect and penalize.

According to M&A practitioners and transaction data from the lower middle market, working capital disputes are among the most common sources of post-closing litigation and arbitration between buyers and sellers. Most of these disputes could be prevented with a clearer upfront conversation about what working capital is, how it is calculated, what a "normal" level looks like for the business, and how it will be handled at closing. Understanding this topic in depth before you reach the PSA negotiation table is not optional — it is essential.

What Is Working Capital?

Working capital is defined as current assets minus current liabilities. Current assets include cash, accounts receivable, inventory, and prepaid expenses. Current liabilities include accounts payable, accrued expenses, deferred revenue, and short-term debt. The resulting figure represents the net liquidity the business has available to fund its operational cycle — the period between when it incurs costs to deliver a product or service and when it collects payment from customers.

A business with positive working capital has more short-term assets than short-term liabilities, meaning it can fund its operations internally. A business with negative working capital is spending money it does not yet have — which may be sustainable if the business model generates rapid cash conversion (certain subscription businesses, for example) but is a potential liquidity risk for most lower middle market businesses.

Why Working Capital Matters in Acquisitions

In a business acquisition, the seller delivers the business to the buyer as a going concern — meaning it should arrive with enough working capital to operate normally from day one without requiring an immediate cash injection from the buyer. The working capital peg is the mechanism that ensures this happens. It defines a target level of working capital (the "peg") that the seller must deliver at closing. If actual working capital at closing exceeds the peg, the buyer pays more; if it falls short, the seller refunds the difference.

The importance of this mechanism becomes clear when you consider what a motivated seller might be tempted to do in the weeks before closing: accelerate collections of outstanding receivables, delay payment of outstanding payables, reduce inventory below normal operating levels, and otherwise drain working capital to maximize the cash they take home at closing. Without a working capital peg, this behavior results in the buyer acquiring a business that is technically cash-poor and operationally short on the resources needed to fulfill existing obligations.

Calculating the Normalized Working Capital Peg

The starting point for any working capital negotiation is a calculation of "normal" working capital — the level the business typically carries during ordinary operations. This is not the working capital at any single point in time, but rather the average across a defined historical period (typically the most recent 12 months) that reflects the business's ongoing operational needs. The Quality of Earnings report, if commissioned during due diligence, typically includes a working capital analysis as a key deliverable.

• Step 1: Pull monthly balance sheets for the trailing 12 months
• Step 2: Calculate working capital at each month-end (current assets minus current liabilities, excluding cash and short-term debt)
• Step 3: Average the monthly working capital figures to establish a normalized baseline
• Step 4: Adjust for known seasonal factors that affect the business's operational cycle
• Step 5: Negotiate the peg with the seller based on the normalized baseline, with a defined dispute resolution process for post-closing adjustments

⚠️ How Sellers Sometimes Drain Working Capital Before Closing

Sellers who are aware of the working capital peg may still attempt to optimize their cash position in the weeks before closing in ways that technically stay within the agreed peg but leave the business operationally thin. Common tactics include accelerating customer invoicing to pull receivables forward, delaying vendor payments to the last allowable moment under payment terms, running inventory below normal replenishment thresholds, and deferring maintenance or other operating expenses that will need to be addressed immediately post-closing.

Sophisticated buyers address these risks by negotiating covenants in the purchase agreement that require the seller to operate the business in the ordinary course between signing and closing — maintaining working capital at normal levels, not accelerating or delaying collections or payments beyond normal practice, and not changing any material business relationships or arrangements. Monitoring compliance with these covenants is one of the seller's obligations between LOI and closing, and material breach is typically a closing condition that gives the buyer recourse.

Post-Closing Working Capital Adjustments

Most purchase agreements include a post-closing working capital adjustment mechanism. At a defined period after closing — typically 60–90 days — the buyer prepares a closing balance sheet and calculates the actual working capital delivered by the seller. If the actual figure is above the peg, the buyer owes the seller the difference. If it is below the peg, the seller refunds the difference. This adjustment process is straightforward when both parties agree on the methodology; it becomes contentious when the methodology was not specified precisely enough in the purchase agreement.

To minimize post-closing disputes, the purchase agreement should define exactly how working capital will be calculated: which current asset and liability line items are included, what accounting policies apply, how inventory is valued, and what the resolution process is for disputed line items. An escrow holdback — a portion of the purchase price held in escrow pending the working capital true-up — is a common mechanism for ensuring the seller has a financial incentive to deliver clean working capital data and for providing the buyer with funds to satisfy any downward adjustment without chasing the seller for a refund. Contact our advisory team to discuss how to structure the working capital provisions in your specific acquisition, or request a valuation analysis that incorporates a working capital assessment.

❓ Frequently Asked Questions

Should cash be included in the working capital calculation?

In most acquisition structures, cash is excluded from the working capital peg calculation and is addressed separately — typically through a "cash-free, debt-free" purchase price convention, where the seller retains all cash and the buyer acquires the business free of funded debt. Including or excluding cash from the working capital peg is a negotiating point that should be explicitly defined in the LOI and purchase agreement, because the treatment significantly affects the economics for both parties.

What is a "peg-free" working capital provision?

Some smaller transactions are structured without a formal working capital peg, particularly where the business has relatively simple balance sheets and the parties trust each other's good-faith operation of the business through closing. In these cases, the purchase price is effectively fixed, and any shortfall in working capital at closing is accepted by the buyer as part of the deal. This approach is simpler to negotiate but increases the buyer's risk of taking over a business with inadequate operational liquidity.

How does working capital differ from net assets?

Working capital (current assets minus current liabilities) is a subset of net assets (total assets minus total liabilities). Net assets includes long-term assets like equipment and real estate, which are typically part of the business's fixed asset base rather than its operational liquidity. In most acquisition conversations, working capital refers specifically to the current-asset and current-liability components, while the long-term asset base is addressed separately in the asset-purchase or stock-purchase mechanics of the deal structure.

Final Thoughts

Working capital is one of those topics that seems dry and technical until it affects a real transaction — and then it becomes very consequential very quickly. Buyers who invest time in understanding the business's working capital dynamics before they submit an LOI are far better positioned to negotiate appropriate peg levels, identify pre-closing working capital manipulation, and structure post-closing adjustment mechanisms that protect their interests. Do not let this be the number that surprises you at closing.