The call I get most often after a closing is not about reps and warranties insurance, not about an earnout dispute, and not about a regulatory hiccup. It is a quiet call, usually three to five months after the closing dinner, where a founder reads me a sentence from a buyer’s notice of objection and asks whether the number at the end of it is real.
The number is almost always real. It is also almost always preventable. The working-capital adjustment is the single most common post-closing money movement in middle-market M&A, and founders chronically misread which part of it matters. They watch the true-up. They should be watching the target.
I want to walk through why, and to name the specific drafting choices at signing that determine whether a working-capital dispute is something that happens to you or something you have already shaped on paper.
The working-capital mechanic, briefly
A merger agreement in the middle market almost always includes a purchase-price adjustment for working capital. The structure is simple in outline. The parties agree, at signing, on a target working-capital number — a dollar figure that represents the normalized level of net working capital the business is expected to deliver to the buyer at closing. At closing, the seller delivers an estimate of actual working capital based on the most recent available balance sheet. After closing, typically within sixty to ninety days, the buyer prepares a final calculation of closing working capital. If the final number is below the target, the difference is paid by the seller back to the buyer, usually out of an escrow funded at closing for that purpose. If the final number is above the target, the buyer pays the seller. The differences are dollar-for-dollar.
The mechanic is borrowed from cash flow logic. A buyer is paying for a business assumed to deliver, day one, enough working capital to operate without needing to inject new cash on day two. The target is the line in the sand. The true-up is the reconciliation. The escrow is the funding mechanism.
That is the contract on paper. The contract in operation has different center of gravity.
Why the true-up is the wrong fight
Founders tend to focus their negotiating energy on the true-up: the post-closing reconciliation, the dispute mechanism, the independent accountant, the threshold below which no adjustment is paid. These are the visible mechanics. They are the part of the section that reads like a procedure.
They are also, in most disputes, the part where the seller has the least leverage.
The reason is structural. By the time a true-up dispute is live, the closing has happened, the money has moved, the escrow has been funded, the seller no longer controls the books, and the buyer’s finance team is the one preparing the calculation. The seller is responding to a number on a spreadsheet that was built by someone else, on accounting policies that were chosen by someone else, applied to a closing balance sheet the seller no longer has full visibility into. The seller’s recourse is the dispute mechanism. The dispute mechanism is usually an independent accountant whose mandate is to resolve disagreements about the closing calculation given the target and the accounting principles — not to revisit what the target should have been, and not to second-guess accounting principles that were locked in months earlier in the merger agreement.
The seller goes into the true-up with a worse evidentiary position than the buyer and with a dispute mechanism that constrains the scope of the fight to areas where the seller is already at a disadvantage. The fight is not lost in the true-up. It is lost at signing.
Where the money actually gets decided
The two clauses that decide most working-capital disputes are the target itself and the defined accounting principles that govern how working capital is computed. Almost everything else in the section is procedure.
Start with the target. A target working-capital number is usually set as the trailing-twelve-month average of normalized net working capital, calculated using the seller’s historical accounting policies as applied during the diligence period. The mechanical question is easy: take twelve monthly balance sheets, apply a working-capital definition, average them. The substantive questions are not. What counts as normalized? Are there one-time inventory builds that should be smoothed out? Are receivables aging assumptions consistent with the seller’s actual collection history? Are deferred revenue and accrued expenses handled the way the seller has historically handled them, or the way the buyer’s auditors want to see them handled? Every one of those decisions moves the target up or down, and every dollar of target movement is a dollar that comes out of seller proceeds at closing or stays in.
The buyer’s diligence team is incentivized to negotiate the target down. A lower target makes it easier for the buyer to achieve a positive variance — closing working capital above target — and gives the buyer cushion against a working-capital miss. The seller’s side is often under-invested in this negotiation because it looks like an accounting exercise rather than a price negotiation, and the seller’s accountants and lawyers are sometimes operating without coordinated direction. The result is a target that was set in conference rooms in March based on assumptions the seller’s CFO did not fully push back on, and which becomes the immovable benchmark in July when the buyer’s notice of objection arrives.
The drafting move is to treat the target negotiation as a price negotiation. The seller-friendly versus buyer-friendly framing applies to the target the same way it applies to the indemnification cap. Every assumption that builds into the target — inventory normalization, receivables aging, accrual policies, deferred items, intercompany balances, related-party items — needs to be examined, contested where appropriate, and locked into the schedule of accounting principles that travels with the agreement.
The accounting principles clause is the second front
The merger agreement will define how closing working capital is to be calculated. The standard phrasing is something like: in accordance with GAAP, applied on a basis consistent with the company’s historical accounting practices, using the methodologies and assumptions set forth in the example calculation attached as Exhibit X. That sentence does a lot of work, and almost all of the work is leverage for whichever side wrote Exhibit X.
The hierarchy embedded in that sentence — GAAP first, historical practice second, example calculation third — sounds neutral. It is not. GAAP is broad enough to permit several legitimate accounting choices for any given balance-sheet item. A buyer’s auditors who want to take a more conservative position on, say, inventory reserves or warranty accruals or revenue recognition can usually find a GAAP-compliant way to do it. If the merger agreement does not specifically lock in the seller’s historical methodology, the buyer’s auditors will be free to argue that their methodology is also GAAP-compliant and is the correct methodology to apply to the closing balance sheet.
The drafting move is to flip the hierarchy. Sellers want historical practice first, GAAP second, and a granular example calculation that locks in every methodology choice. The phrasing matters: “in accordance with the company’s historical accounting practices, and to the extent not addressed thereby, GAAP” is a different sentence than “in accordance with GAAP, applied consistently with the company’s historical accounting practices.” The first puts historical practice on top and uses GAAP as a gap-filler. The second puts GAAP on top and uses historical practice as a tiebreaker between GAAP-permissible alternatives. Sellers want the first. Buyers will draft the second.
Recent Chancery decisions on working-capital disputes have continued to push the analysis into the contract language. The independent accountant’s job is to apply the agreement’s defined principles to the closing balance sheet, not to make first-principles accounting judgments. That means whichever side wrote the principles has the leverage in the dispute. Sellers who do not negotiate the principles carefully are choosing, before they know it, to lose later.
The example calculation is the contract you actually want to read
Most middle-market merger agreements attach an example calculation of closing working capital as a schedule. That example is often dismissed as illustrative. It is not. The example shows how each line item is calculated, what reserves are taken, what is excluded, and what assumptions are made. A buyer who has used the example to demonstrate a conservative methodology — higher reserves, faster receivables aging, lower revenue recognition — has effectively pre-committed to that methodology in the closing calculation.
Sellers who skim the example calculation and approve it without running it against the trailing-twelve-month figures are giving up money they could keep. The example needs to be prepared on the same basis as the trailing-twelve-month average that produced the target. If the example pushes the closing balance sheet toward a more conservative methodology than the target was built on, the buyer has effectively engineered a guaranteed shortfall: the target was computed liberally, the closing calculation will be computed conservatively, and the difference is paid out of escrow.
The escrow that everyone says is small
A working-capital escrow is usually described as small relative to the indemnification escrow. In deals with rep and warranty insurance and no indemnification escrow, founders sometimes assume there is no escrow at all. That is almost always wrong. The structure of a middle-market deal typically funds a separate working-capital escrow of one to two percent of purchase price, and that escrow is the first dollar of recovery if the closing working-capital calculation comes in short of the target.
“Small” is relative. A two-percent escrow on a $100 million deal is $2 million. A target miss of $2 million is a routine outcome on a deal where the working-capital methodology has not been carefully locked in. Founders who think they are taking $98 million off the table at closing are sometimes taking $96 million off the table and watching the rest move twelve weeks later.
The honest summary
The working-capital adjustment is not a back-office reconciliation. It is a price-adjustment mechanism that runs on the documents your deal team negotiated at signing. The true-up is the visible part. The target, the accounting principles clause, and the example calculation are the parts that decide most disputes — and they are the parts that founders are most likely to under-invest in because they look technical.
If you are negotiating a merger agreement and you want a clean exit, fight the target. Demand a granular accounting-principles schedule. Build the example calculation on the same methodology as the trailing-twelve-month average. Push back on every reserve, every aging assumption, every accrual policy that the buyer’s auditors want to shift. The true-up will take care of itself if the target and the principles are right. If they are not, no amount of true-up procedure is going to put the money back in your pocket. The merger agreement is where the money moves, and the working-capital section is where it moves quietly.
The Delaware Court of Chancery’s recent working-capital opinions — available through the Chancery’s published opinions database — continue to reinforce that the dispute is the contract, not first principles. The contract is what you sign at signing. The dispute is what you live with after.
If you are negotiating a working-capital adjustment, reviewing a target number that your buyer’s team has proposed, or preparing a closing balance sheet under a recently signed merger agreement, 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.
