The first time a founder sees a working capital adjustment clause in a purchase agreement, it usually produces one of two reactions. Either it looks like plumbing — boring mechanical language about receivables and payables that the lawyers will handle — or it looks like a minefield written in a foreign language. Both reactions are close to the truth, and neither one is useful.
Here is the thing to know before any other thing: the working capital adjustment is the mechanism that decides whether you write your buyer a check at the closing table or your buyer writes you one, and it can move hundreds of thousands of dollars in either direction on a deal that is otherwise done. You cannot delegate it to the lawyers. You have to understand what it is.
What the buyer is actually buying
When a buyer pays you a purchase price — say, ten million dollars — the buyer is making an assumption about what the business will look like on the day of closing. Specifically, the buyer assumes that the business will have a normal amount of working capital on the books: enough receivables, inventory, and cash to operate; offset by enough payables and accrued expenses to be roughly balanced; so that the buyer can run the business on day one without having to immediately inject more cash.
That “normal amount” is called the target working capital — sometimes “the peg.” The buyer and the seller negotiate it before closing based on a historical average — twelve months, six months, a trailing three-month number, whatever the parties agree. On the closing date, your actual working capital gets measured. If it is higher than the peg, the buyer pays you the difference. If it is lower, you pay the buyer. That is the adjustment.
In a clean deal, the adjustment is small — maybe one or two percent of the purchase price. In a sloppily drafted deal, or a deal where the buyer gets to pick the components of the calculation after signing, the adjustment can reach ten percent of the purchase price or more. Which, on a ten-million-dollar deal, is a million dollars you did not know you were negotiating.
The peg is everything
The single most important number in this whole apparatus is the target itself. The peg is usually set during the last two weeks of diligence, which means it is usually set when everyone is tired and focused on the big issues. It should not be. The peg is a $500,000 line item in its own right on most mid-market deals.
A few points worth fighting over while the peg is being set.
First, whether the measurement is based on the average of twelve months of working capital or on a more recent window. If your business is growing, a trailing-twelve-month average will be lower than a recent three-month average — meaning a lower peg — meaning a higher closing payment. If your business is seasonal, averaging over the wrong window can produce a peg that is wrong by construction.
Second, what goes into “working capital.” The textbook definition is current assets minus current liabilities, but the real definition is negotiated. Deferred revenue is a battleground. So is restricted cash. So are seller-favorable things like prepaid expenses. If your business has unusual balance-sheet items, spell out how each one gets treated in a one-page exhibit.
Third, whether the definition is locked or fluid. The best seller-side structure is to lock the definition of working capital to a specific calculation methodology — ideally the exact same methodology, applied line by line, that was used to compute the historical average for the peg. This prevents the buyer’s accountants from applying a different methodology post-closing and producing a lower adjustment.
The two-stage mechanics
A normal working capital provision operates in two stages. The first happens at closing itself — the seller delivers an estimated closing balance sheet with an estimated working capital number, and the purchase price is adjusted on that basis to an estimated cash amount. The second happens after closing — typically 60 to 120 days later, when the buyer delivers a final closing statement and the actual number is known.
The second stage is where most of the fights happen. The buyer has been running the business for three months, has had its accountants in the books, and is now in a position to argue that the receivables were overstated, the payables understated, the reserves insufficient. You are now on the other side of that argument, with less visibility into what the business has been doing, and trying to defend the number your own team produced.
The provision that controls this fight is the dispute mechanism. A well-drafted provision gives you the right to object to the buyer’s statement within a fixed window (30 days is common), forces the disputed items to be resolved through a neutral accountant, and limits the accountant to deciding only the disputed line items. A poorly drafted provision lets the buyer’s auditor’s number stand if the seller does not object in time, lets the accountant open up every line item, or requires the seller to pay for the whole dispute process.
What changes in a private equity deal
If you are selling to a strategic buyer, the working capital adjustment is usually a mechanical exercise that the parties want to resolve quickly. Strategic buyers have businesses to run. They do not enjoy three months of accounting warfare.
Private equity buyers are a different animal. Their entire model depends on improving margins and returns on the businesses they buy, and post-closing working capital adjustments are one of their standard tools for recovering purchase price. This is not an accusation; it is a structural observation. A well-run PE buyer will bring in their accountants, measure every line item against the strictest defensible methodology, and present a proposed adjustment that is very close to the seller-unfavorable edge of what the contract allows. If you are selling to a PE buyer, the drafting of the working capital provision is one of the top three issues on the deal.
Four rules I use as starting points
None of these are bright-line; all of them are defaults that I push toward when a founder asks me to review a deal.
One: set the peg using a trailing twelve-month average of monthly balances, computed using the same methodology that will apply post-closing. This neutralizes any one-month distortion and locks the methodology to the historical data the buyer has already seen.
Two: include a detailed calculation schedule as an exhibit to the purchase agreement — every line item, every adjustment, with worked historical examples. The exhibit is the single most powerful anti-manipulation device in the adjustment provision.
Three: carve out unusual items. If the business has a contingent liability the buyer has been told about during diligence, it should be off the working capital definition. Do not let the buyer bring it back in post-closing.
Four: set a collar. On a ten-million-dollar purchase price, the working capital adjustment should have a maximum in either direction — maybe $250,000, maybe $500,000. A collar prevents the adjustment from becoming a repricing of the deal and protects both sides from pathological outcomes.
Where to go from here
If you are in the middle of a transaction and someone just handed you a draft purchase agreement, the working capital section is one of the first places to look after the price, the indemnification, and the reps. There is more on the broader seller-side negotiating dynamic in our post on seller-friendly vs. buyer-friendly deal terms, and on reading the financial statements themselves in our piece on how founders and deal teams should read financial statements. The underlying M&A practice context lives on our M&A page.
If you would rather walk through your specific term sheet with someone, feel free to reach out to my firm manager, Magda, at Magda@montague.law, or fill out our contact form. Mention you read this post.
— John
