When buying or selling a business, the agreed-upon price often assumes a baseline financial position at closing. But what happens if that assumption turns out to be off? That’s where working capital adjustments come into play, and failing to properly address them can result in major post-closing disputes.
At Hadri Law, we regularly advise clients on how to structure and negotiate these adjustments to ensure financial fairness and minimize uncertainty in M&A transactions.
What Is Working Capital?
Working capital refers to the short-term liquidity of a business. It’s typically calculated as:
Current Assets – Current Liabilities
This includes items such as:
- Accounts receivable
- Inventory
- Prepaid expenses
- Accounts payable
- Accrued expenses
The purpose of a working capital adjustment is to ensure that, at closing, the business being acquired is transferred with an appropriate level of operational liquidity not stripped of cash or burdened with unplanned liabilities.
How Working Capital Adjustments Work
- Establish a Target Working Capital (TWC):
This is typically based on historical averages or normalized levels required to operate the business. - Measure at Closing:
A working capital calculation is done shortly before or after closing, based on the actual financial data on the closing date. - Adjustment to Purchase Price:
- If actual working capital is below the target, the seller owes the shortfall to the buyer.
- If actual working capital is above the target, the buyer owes the excess to the seller.
Why They Matter
- Protects buyers from overpaying if the seller pulls out value before closing.
- Protects sellers from unexpected post-closing deductions when they’ve left the business well-capitalized.
- Reduces disputes by aligning expectations around cash flow and financial operations at the time of sale.
Common Pitfalls to Avoid
- Unclear definition of working capital: Always define what’s included or excluded (e.g., cash, intercompany receivables).
- Lack of agreed methodology: Disputes often arise over accounting methods, cutoff dates, or inventory valuation.
- No dispute resolution clause: If parties disagree on the final calculation, a resolution process (like a neutral accountant review) should be built into the agreement.
How Hadri Law Helps
- Work alongside your accountant to define a defensible and fair working capital target
- Draft precise language in the purchase agreement to reduce ambiguity
- Negotiate dispute resolution mechanisms to avoid costly litigation
- Protect your position whether you’re a buyer safeguarding your investment or a seller securing your value
Final Thoughts
Working capital adjustments may seem technical, but they can significantly impact the net proceeds of a transaction. Whether you’re acquiring a new business or preparing to sell, it’s critical to get this right and that starts with experienced legal advice.
Book a free consultation or reach us at 437-974-2374 Email: contact@hadrilaw.com to get started.