When business owners start exploring the process of selling their company, the conversation almost always starts with valuation.
“How much can I sell my business for?”
“What multiple will the business command?”
But experienced dealmakers know the headline valuation rarely tells the full story.
One of the biggest contributing factors to the final selling price isn’t the valuation multiple; it’s working capital. In many transactions, working capital is often overlooked, misunderstood, and underestimated.
Our team has been involved in M&A transactions where a seemingly small working capital adjustment changed the economics of a deal by hundreds of thousands of dollars.
Unfortunately, when a seller doesn’t fully understand working capital until later in the process, they might discover that the “purchase price” they had negotiated was not the amount they would ultimately receive.
Working capital can become one of the most technical (and most negotiated) components of a transaction, especially for professional services firms.
Our team has been involved in M&A transactions where a seemingly small working capital adjustment changed the economics of a deal by hundreds of thousands of dollars.
Unlike other types of companies, professional services firms may operate with balance sheets dominated by accounts receivable, deferred revenue, and work in progress. Small changes in how those items are classified or calculated can materially impact a deal’s ultimate value.
Understanding these ideas – how working capital works in an M&A transaction – is essential for any business owner considering a future sale. When structured correctly, it helps business owners avoid surprises, negotiate from a position of strength, and ensure the business continues operating smoothly after closing. When misunderstood, it can unexpectedly erode deal value.
In this article, we’ll break down:
The way working capital works and is determined in an M&A transaction.
Where disputes commonly arise, and how sellers can prepare well before going to market.
How most M&A deals include a working capital peg, which sets the expected amount at closing.
The impact on purchase price if the business delivers more or less than the “peg.”
Why preparing financials in advance helps sellers avoid unexpected adjustments during due diligence.
What Working Capital Actually Means in an M&A Transaction
In basic financial terms, working capital is defined as:
Current Assets – Current Liabilities
But in an M&A transaction, the definition becomes more nuanced.
Once both parties have come to an agreement on the purchase price, both parties will sign a Letter of Intent (LOI) that outlines the agreed-upon financial terms. The LOI defines many elements of the planned transaction and almost always contains a critical and frequently sticky clause related to working capital. The Working Capital Clause generally reads to the effect of “the buyer will deliver sufficient working capital to achieve the operating results.” This is also sometimes referred to as adequate working capital.
The determination of “sufficient working capital” is even more subjective than Adjusted EBITDA. There is no commonly accepted methodology to compute “sufficient working capital.” As a result, failing to put careful thought into the methodology and agreed upon definition before signing an LOI tends to lead to some very contentious discussions…and to the collapse of many deals.
Most middle-market acquisitions are structured on a cash-free, debt-free basis, meaning the seller retains excess cash and pays off outstanding debt before closing. The buyer, in turn, expects to receive a business with a normalized level of operating working capital that allows the company to continue operating normally.
While the concept sounds simple, defining what qualifies as “excess cash” can become another point of negotiation. Businesses often maintain a baseline level of cash required for day-to-day operations and determining that level requires an understanding of payroll cycles, billing schedules, and payment timing. In other words, not all cash on the balance sheet is necessarily excess.
Think of it like selling a car: the owner will remove personal items but isn’t going to drain the fuel tank before handing over the keys.
For professional services firms, working capital typically includes operating items such as:
Current Assets
Accounts receivable
Work in progress
Prepaid expenses
Current Liabilities
Accounts payable
Accrued expenses
Deferred revenue1
Cash and interest-bearing debt are generally excluded from the calculation.
The key point is that working capital in an acquisition is not simply an accounting formula. It is a negotiated mechanism designed to ensure operational continuity after the transaction closes.
Action items:
The Working Capital “Peg”: The Number That (Quietly) Impacts Deal Value
As noted above, most M&A transactions include what is known as a target working capital level, sometimes called the working capital “peg.” This number represents the amount of working capital the buyer expects the business to deliver at closing.
The peg is typically calculated using an average of historical working capital levels (often over the trailing 12 months). If the business delivers more working capital than the peg, the purchase price is increased. If it delivers less, the purchase price is reduced.
Example of Working Capital When Selling an Agency
Let’s assume the parties agree to 5X adjusted EBITDA of a company making $2 million, or $10 million. Next, let’s assume that working capital is $2 million at closing. Here is the impact of two different Pegs to the seller, one at $1 million and one at $3 million:
In Example A, the seller ends up with $2 million more in net proceeds than in Example B.
The Peg is compared to actual net working capital delivered at closing, and the difference in these numbers is a dollar-for-dollar adjustment to the purchase price. The reason for this is that buyers want to make certain that sellers don’t drain the working capital out of the business prior to closing by, for example, delaying paying vendors, depleting inventory, incentivizing customers to pay their accounts receivable balances early or perhaps providing an advance for future services, and then withdrawing the cash generated by these tactics. Without a working capital adjustment, the buyer would then end up with a company that has no receivables to be collected in the near future, no inventory, and past due payables.
Action items:
How Buyers Calculate the Working Capital Target
Determining the working capital peg may sound straightforward, but in practice it can become one of the more technical aspects of negotiating a transaction. Different buyers may propose different methods for calculating the target.
Common approaches include:
Trailing 12-month average
Trailing 6-month average
Seasonal or normalized averages
Projected working capital based on growth
The chosen methodology can significantly impact the peg. Buyers will often select the period to be measured to try and make the expected impact most favorable to them. Fortunately, at TobinLeff, we know these tactics, as well, and are always alert for them when we are representing sellers in order to negotiate in a way that is favorable to both parties.
For example, consider a professional services firm that has grown rapidly over the past year. The working capital required to support current operations may be significantly higher than it was twelve months earlier.
If the peg is calculated using a 12-month average, it may understate the company’s current working capital needs. A buyer might prefer a shorter averaging period, which could increase the peg and reduce the seller’s proceeds.
This is why choosing an experienced M&A advisor to properly prepare the financials and analyze multiple scenarios before negotiations begin can increase your cash at closing.
Action items:
Financial Preparation Before a Sale Matters
Companies that prepare their financials in advance of a sale typically experience fewer surprises during due diligence and proactively avoid potential deal killers.
In particular, consistent accounting practices help ensure working capital calculations align with the company’s reported earnings. This alignment is critical because enterprise value in most professional services transactions is based on Adjusted EBITDA. If balance sheet accounts are misclassified or inconsistently recorded, working capital adjustments can unintentionally distort deal economics. Strong financial discipline helps prevent those issues.
Best practices often include:
Maintaining accurate monthly accruals
Recording bad-debt reserves for receivables
Tracking deferred revenue accurately
These may seem like routine accounting steps, but they can significantly affect how working capital is calculated during a transaction. The consistency, completeness, and reliability of your financials all directly impact your ability to make a deal and get the selling price that you want.
Action items:
Where Working Capital Disputes Commonly Arise
Even well-structured deals can encounter disagreements around working capital calculations. These disputes often involve the classification of specific balance sheet items.
Common areas of debate for professional services firms might include:
Accrued bonuses
Client retainers
Deferred revenue
Advertising or media advances
Prepaid expenses
Tax liabilities
For example, a buyer may attempt to classify certain accrued expenses as debt rather than operating liabilities. Doing so can effectively increase the working capital requirement and reduce the seller’s net proceeds.
Similarly, inconsistent accounting practices (such as irregular accruals of bonus or profit sharing; waiting until year end to write off bad debt; unbillable costs that were not expensed until year end; failure to accrue expenses until receipt of a vendor invoice) can distort historical working capital averages. This is why many firms benefit from conducting a pre-sale financial review well before entering the market.
Action items:
TobinLeff founder David Tobin sits down with partner Chuck Gottschalk to discuss how working capital adjustments work in real transactions, and why they often surprise sellers who are preparing to exit their businesses.
In Sum: Working Capital Deserves More of Your Attention
For many business owners, working capital continues to be one of the most confusing aspects of selling a company. Yet it is also one of the more crucial mechanisms that can quietly influence the final economics of a transaction.
You’ve poured yourself into your business, and understanding how working capital works, and adequately preparing for those negotiations in advance, can help ensure that the value you have built in your business translates into the best possible outcome when the time comes to sell.
1 For purposes of working capital, only deferred revenue that has not been collected is treated as a current liability. Deferred revenue that has been collected is treated as debt and excluded from current liabilities.
Thinking about selling your professional services firm in the next few years?
If you want to have a conversation with one of our experts in working capital, we would be delighted to have a call to talk about our real-world experiences and one example we will be sure to discuss is where we increased a seller’s net proceeds by $6 million as a result of our expertise in this area.
Working capital is just one of many financial factors that can impact the outcome of a transaction.
TobinLeff’s has helped owners of leading marketing agencies, technology, and professional services firms realize outstanding outcomes — strong valuations with buyers whose values, culture, and vision align.
Schedule your confidential conversation today.
Frequently Asked Questions About Working Capital in M&A
What is working capital in an acquisition?
Working capital in an acquisition refers to the operating liquidity required for the business to continue functioning after closing. It is typically calculated as operating current assets minus operating current liabilities.
What is a working capital peg?
A working capital peg is the negotiated target level of working capital that must be delivered at closing. If the actual working capital differs from the peg, the purchase price is adjusted accordingly.
Why do buyers require working capital at closing?
Buyers expect the acquired company to continue operating normally immediately after the transaction. Delivering a normalized level of working capital ensures the business has the liquidity necessary to meet short-term obligations.
How is working capital calculated for professional services firms?
For most professional services businesses, working capital includes accounts receivable, work in progress, prepaid expenses, accounts payable, accrued liabilities, and deferred revenue. Cash and debt are typically excluded.
Can working capital adjustments affect the purchase price?
Yes. Working capital adjustments are typically calculated on a dollar-for-dollar basis and can significantly increase or decrease the seller’s final proceeds.