What a Working Capital Adjustment Is
A working capital adjustment ensures a business is delivered with a normal, agreed level of working capital, with the purchase price trued up at closing for any difference. Working capital, roughly, current assets (receivables, inventory) minus current liabilities (payables), is the cash the business needs to keep operating. This adjustment, a common purchase price adjustment, prevents surprises and unfairness around how much of it comes with the business.
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Why It Exists
The adjustment solves a fairness problem. Without it, a seller could strip cash and collect receivables before closing, or run down inventory, leaving the buyer an under-capitalized business that needs an immediate cash infusion. Conversely, the seller shouldn't have to leave excess working capital for free. The adjustment ensures the business arrives with the normal amount it needs to run, protecting both sides. It's about delivering the business "as it operates," not stripped or padded.
The Target (Peg) and the True-Up
The mechanism works around a target (or "peg"), the agreed normal level of working capital, usually based on the business's historical average. At closing, the actual working capital is measured against the peg: if actual is above the target, the buyer pays more (the seller left extra); if below, the price is reduced (the seller left less). This true-up is often finalized shortly after closing once final numbers are known.
Negotiating the Peg
Setting the peg is heavily negotiated, because it directly affects the final price. Both sides analyze the business's historical working capital to agree on a normal level, accounting for seasonality and trends. A peg set too high favors the buyer; too low favors the seller. Getting it right requires understanding the business's working-capital cycle, which is why this is worked out carefully with accountants during the deal.
The Takeaway
Working capital adjustments are standard in business sales, especially larger ones, and they materially affect the final amount that changes hands. Both buyers and sellers should understand the peg, how it's calculated, and how the true-up works, so there are no surprises at closing. Address it clearly in the LOI and purchase agreement, with CPAs involved. See purchase price adjustments and earnouts.
Note: This article is general educational information, not legal, tax, or investment advice. Consult qualified professionals about your specific situation.
Frequently Asked Questions
What is a working capital adjustment?
It's a mechanism ensuring a business is delivered with a normal, agreed level of working capital (current assets like receivables and inventory minus current liabilities like payables), with the purchase price trued up at closing for any difference. It prevents the seller from stripping cash and receivables or the buyer from receiving an under-capitalized business.
How does a working capital adjustment work?
The parties agree on a target or peg, the normal level of working capital based on the business's history. At closing, actual working capital is measured against the peg: if actual is above target, the buyer pays more; if below, the price is reduced. This true-up is often finalized shortly after closing once final numbers are known.
What is the working capital peg?
The peg (or target) is the agreed normal level of working capital the business should be delivered with, usually based on its historical average and accounting for seasonality and trends. It's heavily negotiated because it directly affects the final price, a peg set too high favors the buyer, and too low favors the seller.
Why do deals include working capital adjustments?
For fairness. Without one, a seller could strip cash and collect receivables before closing, leaving the buyer an under-capitalized business, or the seller might have to leave excess working capital for free. The adjustment ensures the business arrives with the normal amount it needs to run, protecting both sides, and it's standard in most sizable deals.
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