Working Capital in M&A: What Sellers Need to Know

If I could warn every business owner about one thing before they sign a letter of intent, it would be this: the purchase price on the LOI is not the number you'll receive at closing. Working capital adjustments are the single most common source of post-LOI surprises, and I've watched sellers lose $100,000 to $500,000 because they didn't understand the mechanism until it was too late.

The concept isn't complicated once you see it clearly. But buyers and their advisors count on sellers not paying attention to this section of the LOI — because the working capital "peg" is where sophisticated buyers quietly shift economics in their favor.

What Working Capital Means in an M&A Context

In an accounting textbook, working capital is current assets minus current liabilities. In an M&A deal, it's more specific. It's the operating liquidity — the cash tied up in accounts receivable, inventory, prepaid expenses, minus what you owe in accounts payable, accrued expenses, and other short-term obligations — that the business needs to function day-to-day.

Here's the key distinction: cash and debt are typically excluded. The buyer is purchasing the business on a "cash-free, debt-free" basis, meaning you keep excess cash and pay off outstanding debt at closing. Working capital is what sits between those two — the operational float the business needs to keep running.

Think of it this way: if you run a distribution company, you have $400K in inventory on your shelves and $250K in receivables from customers. You also owe $180K to suppliers. That net $470K is working capital — and the buyer expects to receive it as part of the deal, because without it, the business can't operate on Day 1.

The Peg: Where the Real Negotiation Happens

Every M&A transaction includes a "working capital peg" — an agreed-upon target level of net working capital that the seller must deliver at closing. The standard approach is to set the peg at the trailing twelve-month (TTM) average of net working capital, calculated monthly.

Here's how it works mechanically. The buyer and seller agree on a peg — let's say $300,000. At closing, the seller delivers estimated working capital of $310,000. Then, 60-90 days after closing, the buyer's accountants prepare a final working capital calculation. If the actual number comes in at $280,000, the seller owes the buyer $20,000 (the difference between $280K actual and $300K peg). If it comes in at $340,000, the buyer owes the seller $40,000.

This post-closing adjustment is called a "true-up," and it's almost always a one-way street against the seller. In my experience, roughly 70% of true-ups result in money flowing from seller to buyer.

A Concrete Example: How $200K Swings the Deal

Let me walk through a real-world scenario I see constantly with manufacturing and distribution businesses.

The agreed purchase price was $4,000,000. The peg was set at $560,000 (the TTM average). But by closing, the seller had aggressively collected receivables and drawn down inventory — natural things that happen when an owner knows they're selling. The result: a $200,000 true-up payment from seller to buyer, reducing the effective purchase price to $3,800,000.

That $200,000 didn't show up in any headline number. The seller told friends they sold for $4 million. But they walked away with $3.8 million. This happens in virtually every deal.

The Traps Sellers Fall Into

Trap #1: Seasonal Businesses and the TTM Average

If your business is seasonal — landscaping, HVAC, retail, construction — the TTM average can be deeply misleading depending on when you close. A landscaping company that closes in November will have minimal receivables and inventory compared to its July peak. If the peg is set at the annual average, the seller will owe a massive true-up because the business naturally has less working capital in winter.

The fix: negotiate the peg based on the working capital level that's typical for the closing month, not the annual average. Better yet, negotiate a "seasonal peg" that adjusts by month. I've seen this save sellers $150,000+ on seasonal businesses.

Trap #2: Accelerating Collections Pre-Close

Sellers instinctively speed up collections before closing — they want cash in hand. But every dollar collected reduces accounts receivable, which reduces working capital below the peg, which triggers a true-up. You're essentially paying the buyer for collecting your own receivables.

The smart move: maintain your normal collection cadence. If a customer pays early, great — but don't push for it. And if you have large receivables that are near the peg measurement date, understand that collecting them might cost you dollar-for-dollar via the true-up.

Trap #3: The Definition of "Working Capital"

The single most important negotiation point isn't the peg amount — it's the definition of what's included. Buyers will try to include items that inflate the peg (making it harder to meet) or exclude items that deflate it. Watch for these specifically:

• Deferred revenue: If you collect payment upfront (SaaS, subscription businesses, annual contracts), deferred revenue is a current liability. Including it in working capital raises the peg and creates a built-in trap.
• Customer deposits: Similar to deferred revenue — these inflate current liabilities and lower your working capital number.
• Intercompany receivables: If you have related entities, buyers will try to include receivables from those entities that may never actually be collected.
• Stale inventory: Buyers love to write down inventory during the true-up period, arguing that certain items are slow-moving or obsolete. This directly reduces working capital below the peg.

How to Protect Yourself

Having worked on the sell-side of dozens of these negotiations, here's what actually moves the needle for sellers.

Negotiate the peg aggressively before signing the LOI. Once you're in exclusivity, your leverage evaporates. The LOI stageis where this fight needs to happen. Push for the lowest defensible peg — ideally the trailing 6-month average if it's lower than 12, or a normalized number that excludes anomalous months.

Insist on a collar or dead band. A collar means no true-up occurs unless working capital at closing deviates from the peg by more than a threshold — typically $25,000-$100,000 depending on deal size. This prevents nickel-and-dime adjustments and gives both sides some breathing room.

Lock down the definitions early. Attach an example working capital calculation as an exhibit to the LOI. Specify exactly which accounts are included and excluded. Agree on accounting policies (GAAP basis, same policies as historical periods). This prevents the buyer from redefining terms during the true-up.

Get a quality of earnings report before going to market. A sell-side QofE will calculate your normalized working capital — giving you ammunition to negotiate the peg from a position of knowledge, not guesswork. It costs $20,000-$50,000 but regularly saves multiples of that in the working capital negotiation alone.

Maintain normal business operations through closing. Don't accelerate collections. Don't delay vendor payments. Don't draw down inventory. Run the business as if you're keeping it. The moment you start "optimizing" for closing, you create working capital gaps that the true-up will catch.

Industries Where Working Capital Bites Hardest

Not every business faces the same working capital risk. In my experience, these industries see the largest true-up adjustments:

• Distribution and wholesale: High inventory and large AR balances mean $200K-$500K swings are routine on $5-15M deals.
• Manufacturing: Raw materials, WIP, and finished goods inventory create massive working capital needs that fluctuate with production cycles.
• Construction and contracting: Retainage, progress billings, and job-level WIP make working capital calculations extraordinarily complex.
• Healthcare practices: Insurance receivables with 60-90 day collection cycles create timing-dependent working capital levels.
• Staffing firms: Payroll is funded weekly but clients pay in 30-60 days, creating a structural working capital need that's easy to underestimate.

By contrast, service businesses with little inventory and fast collections — consulting firms, marketing agencies, IT services — typically have minimal working capital adjustments. The peg is small, the swings are small, and it rarely becomes a major negotiation point.

What Your Advisor Should Be Doing

A competent M&A advisorwill build a working capital analysis before you go to market — monthly calculations for 24+ months, normalized for one-time items, with seasonal patterns identified. They'll use this to set a defensible peg in the LOI and push back when buyers try to manipulate the definition.

If your advisor isn't talking to you about working capital before you sign the LOI, that's a red flag. It means either they don't understand the mechanics, or they're focused on closing the deal rather than protecting your economics.

The Bottom Line

Working capital adjustments are not a technicality — they're a core economic term of the deal. On a $5 million transaction, a $200K working capital swing represents 4% of the purchase price — real money that flows directly between buyer and seller. Sellers who understand this mechanism negotiate better pegs, maintain appropriate business operations through closing, and avoid the gut-punch of writing a six-figure check 90 days after they thought the deal was done.

The purchase price on the LOI is a starting point, not a finish line. Working capital is where the finish line actually gets drawn.