A working capital target can move a meaningful amount of cash between seller and buyer at closing. It is often discussed late in a transaction, after months spent on price, buyers, and diligence. That is too late. An owner who understands the target before going to market can protect both the purchase price and the cash they expect to retain.
Working capital is not an accounting technicality in an M&A deal. It is the operating fuel left in the business on the closing date. If a buyer pays for a company based on its earnings and expects it to continue operating normally on Monday morning, the buyer will expect a normal level of receivables, inventory, prepaid expenses, payables, and accrued expenses to remain.
What a Working Capital Target Means in a Sale
The working capital target, often called a working capital peg, is the agreed amount of normalized net working capital that must be delivered at closing. Net working capital usually means current operating assets less current operating liabilities. Cash, debt, income taxes, and certain unusual balances are commonly excluded, but the definitions in the purchase agreement control.
A simple example makes the point. Assume a business historically carries $4 million of accounts receivable and inventory, offset by $2.5 million of accounts payable and accrued expenses. Its normalized net working capital is $1.5 million. If the agreed target is $1.5 million and the company delivers $1.2 million at closing, the buyer generally receives a $300,000 downward adjustment to the purchase price.
If the company delivers $1.8 million instead, the seller may receive a $300,000 upward adjustment. In practice, the calculation is rarely that simple. The dispute is usually not about subtraction. It is about what is normal, what belongs in the calculation, and whether the balance sheet reflects the business as it was actually run.
For a founder-owner, this can feel counterintuitive. You may view cash collected before closing as your cash. The buyer may agree, but still expect you to leave enough receivables, inventory, and other operating assets to support the business. The distinction between excess cash and working capital must be clear before the deal documents are signed.
How Buyers Set the Working Capital Target
Most buyers begin with historical monthly balance sheets. They may review 12 months, 24 months, or longer if the company has significant seasonality, rapid growth, a recent acquisition, or a change in accounting practices. The goal is to identify the level of working capital required to operate in the ordinary course.
A target based on a simple 12-month average is common, but it is not always fair. A seasonal distributor that builds inventory in advance of its busiest quarter should not necessarily be measured against the same target in every month. A company that grew quickly in the final year may need more working capital than its earlier monthly averages suggest. Conversely, an unusual inventory build, a delayed customer payment, or a one-time supplier dispute can distort the average.
The right target depends on the operating cycle. A service business with little inventory may be driven by unbilled revenue, deferred revenue, receivables, and payroll accruals. A manufacturer may be driven by raw materials, work in process, finished goods, and supplier terms. A business that receives customer deposits may have negative working capital, which can be entirely appropriate if it has been managed that way consistently.
The question is not whether the target is high or low in isolation. The question is whether it reflects the normal level needed to run the business after closing without forcing the buyer to inject cash immediately.
The target should match the deal structure
The purchase agreement determines how working capital affects the economics. In a cash-free, debt-free transaction, the seller usually retains cash and pays off debt, while delivering the agreed working capital target. That structure is common in middle-market transactions, but the details matter.
Some deals use an estimated closing statement. The parties agree on an estimate of closing working capital, calculate the payment at closing, and then perform a post-closing true-up once final numbers are available. A true-up is a reconciliation process that adjusts the purchase price after closing if the estimate was wrong.
Other deals use a locked-box approach, more often in certain cross-border transactions. In that structure, the price is based on a historical balance sheet and the seller agrees not to remove value from the company outside permitted items between the locked-box date and closing. The working capital analysis still matters, but the mechanics differ.
Earnouts, vendor take-back notes, and rollover equity should also be considered separately from working capital. They can affect the total value received by a seller, but they do not replace the need for a clear closing balance sheet calculation.
The Balances That Cause Problems
A buyer and seller can agree on a headline price and still disagree materially over the working capital definition. The areas below deserve attention early in the process.
Accounts receivable. Buyers may challenge overdue receivables or request a reserve for accounts that may not be collectible. If your company has historically collected older receivables, the evidence matters. Aging reports, collection history, credit memos, and post-period cash receipts can support the balance.
Inventory. Obsolete, slow-moving, damaged, consigned, or improperly valued inventory can lead to reductions. Owners should not wait for buyer diligence to identify items that have not moved in two years. A clean inventory count and support for costing methods are worth having before a process begins.
Accrued expenses. Unrecorded bonuses, vacation pay, customer rebates, warranty claims, commissions, and freight liabilities can reduce working capital. The issue is often timing. If an expense relates to the period before closing but is not recorded until afterward, the buyer will argue that it belongs in the closing calculation.
Deferred revenue and customer deposits. These balances represent an obligation to deliver future goods or services. They may be treated as a current liability, but the economics can vary. If the business has already incurred most of the cost to fulfill the obligation, a dollar-for-dollar reduction may not reflect reality.
Related-party and non-operating items. Loans to shareholders, personal expenses, unusual intercompany balances, and non-recurring receivables should be identified well before a buyer sees the financial statements. These items are often removed from the calculation, but they can raise broader diligence questions if left unexplained.
Why the Target Can Be More Important Than the Headline Price
A buyer may offer a strong enterprise value, then seek a working capital target that is higher than the company has historically maintained. The result is that the seller must leave more value in the business at closing. That does not necessarily make the offer unacceptable. It does mean the offer must be evaluated on total cash proceeds and risk, not on the headline number alone.
Consider two buyers offering the same enterprise value. One proposes a target consistent with the company’s normal operating cycle and a narrow definition of working capital. The other proposes a higher target, includes more liabilities in the calculation, and reserves broad discretion in the post-closing true-up. The second offer may produce less cash at closing and more exposure to a later dispute.
This is particularly relevant for owners who have managed working capital tightly for years. If you have accelerated collections, negotiated favorable supplier terms, or run lean inventory, the buyer may question whether the balance at closing is sustainable. Your operating history can answer that question, but only if it is presented clearly.
Prepare the Analysis Before You Negotiate
The best time to address a working capital target is during sale preparation, not in the final days before closing. Start with monthly historical balance sheets and reconcile them to your general ledger. Identify accounting changes, unusual months, related-party items, and material fluctuations. Then assess the company’s actual cash conversion cycle: how long it takes to turn inventory or labor into collected cash, and when suppliers must be paid.
Management should also decide which items are truly operational. There is no universal answer for prepaid insurance, deposits, deferred revenue, bonus accruals, or customer rebates. The right treatment depends on the business and the deal. Consistency matters. If an item was included in the historical working capital calculation, excluding it at closing requires a sound reason.
Documentation is valuable. A buyer is more likely to accept a position supported by monthly schedules, aging reports, inventory records, and a clear explanation from the finance team than by a last-minute assertion that a balance is normal. The same preparation helps prevent disruption to staff and customers while the transaction is underway.
An experienced M&A advisor can model the likely working capital peg alongside the purchase price and other transaction terms before letters of intent are compared. At Beacon Advisors, that analysis is part of looking beyond the headline offer, so an owner can understand what each proposal means in cash, risk, and closing mechanics.
Before you enter a sale process, ask for a confidential valuation conversation that includes a review of your historical working capital. It can expose an avoidable issue while you still have time to address it on your terms.