Negotiating Working Capital: Maximizing M&A Valuation

May 20, 2018

The working capital issue can surprise a seller and cost the seller millions of dollars. Many business owners assume the purchase price for their business will be based on a multiple of some financial metric, e.g. revenue or EBITDA. This is generally true, but a buyer typically requires a minimum amount of “working capital” on the balance sheet when they buy the business to ensure there are no immediate liquidity issues. A buyer does not want to pay twice, once to buy the business and then have to inject capital at the closing of an M&A transaction to keep the business running.

Working Capital Calculation

The most common method for calculating a working capital hurdle is based on the average monthly adjusted working capital over a 12-month period. The monthly working capital is determined according to the stock-purchase or asset-purchase agreement. An agreement might, for example, define working capital as: (i) current assets; (ii) less current liabilities (excluding debt); (iii) less items that are excluded by definition in the purchase agreement; or (iv) plus or minus pro forma or due diligence adjustments determined during the financial due diligence analysis (such as the need for a bad-debt allowance).

A 12 month analysis is not appropriate in every situation. If the company is experiencing substantial growth, for example, a 12 month working capital analysis might not reflect the company’s current working capital needs.

If revenues grew 75 percent in the second half of the year, it’s likely that the working capital at closing will be higher than a hurdle calculated on a 12 month average, which would drive up the purchase price. In this case, the hurdle might best be calculated on the most recent three or six months.

Seasonality should also be considered. Twelve month-hurdle calculations generally factor out seasonality, but, depending on whether the purchase is made in or out of season, actual working capital could be much higher or lower. If the deal is made during peak season, working capital is likely to be higher than average, and the buyer would be required to pay more. If the transaction is completed at an off-peak time, working capital will probably be lower than average. With a seasonal business, it might make sense to calculate the hurdle based only on the seasonal or nonseasonal period, depending on when the purchase occurs.

Prepare Estimates on Working Capital Early

For the seller, it is important to address the working capital issue early and prepare for the negotiations on the issue. In fact, sellers would be best suited to understand the impact of working capital well before they begin the process of selling their company.

It behooves the seller to model several different scenarios of working capital, i.e. 12 months, 9 months, 6 months and 3 months. Then the seller will know which is most favorable and can put that scenario on the negotiating table as the opening salvo. Also calculating “excess cash”, which is discussed below, is critical in preparation for negotiations with the buyer.

Financial Due Diligence

The seller should expect extensive financial due diligence in any case, but in particular regarding the working capital issue. The buyer will be interested to:

  • Understand how management understands, analyzes and manages working capital;
  • Identify and calculate working capital ratios, e.g. days sales outstanding and days payables outstanding, etc.; and
  • Assess seller’s ability to manage working capital through deferring payables or accelerating accounts receivable collections.

Post Closing True-up

Usually 30 to 90 days after closing, the buyer presents an actual balance sheet as of the closing date to seller. The parties compare this balance sheet to the estimated balance sheet presented at closing and true up (adjust) any differences in working capital.

To the extent that the actual net working capital exceeds the hurdle, then the seller is owed the difference in a cash payment. If the business shows a deficit relative to the hurdle, then the seller owes the buyer the difference. Due to unpredictable nature of sales, billing, and collections, there is always a payment one way or another.

The Role of Cash

A common structure in an M&A transaction is as a cash-free, debt-free (CFDF) transaction. Under a CFDF deal, the cash and debt would remain with the seller while the acquirer takes the other business assets. One of the reasons for the popularity of CFDF deals is that the seller is generally able to manipulate working capital in the period leading up to transaction’s closing, i.e. accelerating collection of accounts receivable. To mitigate disputes over the most liquid component of working capital (cash), the CFDF structure is often attractive.

With an accountant’s help, the seller should calculate working capital required to continue business as usual, including near term growth; then determine the cash component of working capital. All cash beyond that should be “excess cash” and the seller’s to keep, including excess cash generated between the time a purchase price is negotiated and when the transaction actually closes.

The seller can distribute excess cash in advance of an M&A transaction but a higher tax rate may apply to cash distributions. Typically the seller negotiates a dollar for dollar price adjustment upward for excess cash left in the company at the time of acquisition. This could permit shareholders to receive more favorable capital gains treatment.


The working capital issue is highly complex and can be one of most contentious issues in M&A negotiations, but if the seller prepares early and thoroughly, negotiations will go smoothly and the seller will save millions.