Key Insight
Working capital is the last number negotiated and the most likely to kill a deal at the finish line. Define it precisely in the LOI — not the purchase agreement.
What Working Capital Includes
Working capital = current assets − current liabilities.
Current assets (typically included):
- Cash and cash equivalents (sometimes excluded — deal-specific)
- Accounts receivable
- Inventory
- Prepaid expenses
Current liabilities (typically included):
- Accounts payable
- Accrued expenses
- Deferred revenue
- Short-term portions of long-term debt (sometimes excluded)
Why Working Capital Is Contested
The controversy comes from two sources: what's included and what the target should be.
Most acquisition agreements require the seller to deliver a normalized level of working capital at closing — enough to run the business without an immediate injection of additional cash. If working capital at closing falls short of the target, the purchase price adjusts down by the deficiency. If it exceeds the target, the purchase price adjusts up.
The problem: sellers want the target to be low (they keep more cash) and buyers want it to be high (they take over a better-capitalized business). Neither party quantifies this precisely in the LOI, and by the time it comes up in purchase agreement negotiations, both sides have invested too much to walk away cleanly.
Setting a Working Capital Target
The target is typically set as the trailing twelve-month average of working capital, calculated monthly. This prevents the seller from pulling cash out of the business in the months before closing to artificially reduce the target.
The LOI should specify:
- The working capital target amount (or the methodology for calculating it)
- Whether cash is included or excluded from the calculation
- The measurement date and process for the closing balance sheet
- The post-close true-up period (typically 60-90 days after closing)
A buyer is under LOI for a $2.1M deal. The seller, knowing the working capital target was vaguely defined, collects receivables aggressively in the final 60 days and delays payables. At closing, working capital is $85,000 below the implied target. The buyer either renegotiates (takes six weeks), accepts the shortfall (pays more than agreed), or kills the deal. Defining the target with a trailing-average methodology in the LOI eliminates this scenario.
Working Capital in SBA Deals
SBA lenders require a working capital allocation as part of the total project cost. The SBA's position: the business needs enough liquidity to operate immediately post-close, and that liquidity is part of the acquisition cost. Buyers should model working capital needs separately from the purchase price and include it in their equity injection and total loan calculations.
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