Ask any M&A professional about the most common issues in closing deals, and “working capital disputes” will likely top their list. Working capital is a complex concept, especially for business owners selling their companies for the first time. Without a proper understanding, sellers can face unexpected surprises and frustrations during the transaction process.
What is Working Capital?
Working capital is the lifeblood of a business, the fuel that keeps it running smoothly. Think of it this way: when you buy a car, you expect it to come with a reasonable amount of gas. Similarly, business buyers expect the company they purchase to include a "normal" level of working capital to keep operations flowing.
In simple terms, working capital is the difference between a company’s current assets (e.g., accounts receivable or AR) and current liabilities (e.g., accounts payable or AP). For most HVAC companies and similar businesses, AR and AP make up about 90% or more of their working capital. By subtracting AP from AR, you arrive at the net working capital (NWC), which is a critical metric in any M&A deal.
Why Working Capital Causes Disputes
The root of most working capital disputes lies in mismatched expectations. Sellers often assume they will keep some or all of the accounts receivable at closing, adding the AR minus AP value to their expected sale price. While this assumption might seem logical at first glance, it doesn’t hold up when you view working capital as the fuel the buyer needs to operate the business from day one.
From the buyer's perspective, it makes sense for the AR and AP to transfer with the business. However, many sellers struggle with this concept, particularly contractors who may have large invoices outstanding for 60-90 days and who pay off their liabilities quickly. The result? Sellers are often shocked to learn they won’t receive the AR minus AP figure in addition to the purchase price. This misunderstanding can derail a deal entirely.
How Working Capital Works in M&A Deals
To clarify how working capital is handled, let’s start with the structure of an M&A transaction. The following structure is typical for deals where the owner's business is larger than $500K in EBITDA.
Cash-Free, Debt-Free: The seller keeps all cash at closing and pays off all outstanding debt.
Working Capital Transfer: The buyer receives the assets or stock of the business, including the working capital, as part of the deal.
This structure is typically outlined in the Letter of Intent (LOI), which includes terms specifying that working capital will transfer with the business. Unfortunately, LOIs are often packed with legal jargon, and sellers may not fully understand what they’re agreeing to—especially if their advisor isn’t adequately explaining the terms.
The standard approach described in most LOIs is the target working capital method.
The Target Working Capital Approach
The target working capital method protects buyers from manipulation and ensures a fair transfer of working capital at closing. Here’s how it works:
Establishing a Target: The target is typically based on the business’s average net working capital over the past 12 months. For example, if ABC HVAC company’s average AR over a year is $100K and its average AP is $25K, the target net working capital is $75K.
Protecting Buyers: Without a target, sellers could game the system by collecting AR aggressively (converting it to cash) while delaying AP payments, leaving little to no working capital for the buyer. By setting a target, buyers ensure they receive the amount of working capital the business typically requires.
Adjustments: At closing or during a post-closing lookback period (usually 60-90 days), the final working capital is compared to the target. If the delivered working capital falls short, the buyer adjusts the purchase price downward. If it exceeds the target, the purchase price increases.
Example Scenarios
To illustrate, let’s revisit ABC HVAC Company:
Scenario 1: Shortfall
ABC’s target working capital is $75K, but at closing, AR is $50K (due to aggressive collections), and AP is $50K (due to delayed payments). The net working capital is zero. The buyer reduces the purchase price by $75K to account for the shortfall.
Scenario 2: Surplus
If ABC delivers $125K in AR and keeps AP flat at $25K, the net working capital at closing is $100K. Since this exceeds the target by $25K, the buyer increases the purchase price by $25K.
Avoiding the Working Capital Landmine
If you’ve made it this far, congratulations—you now know more about working capital than most business owners heading into an M&A deal! While working capital can feel overwhelming, understanding the target approach early can save sellers from surprises and disputes later.
With the help of a knowledgeable advisor, sellers can grasp the essentials and avoid costly misunderstandings. It’s critical to align expectations before signing an LOI, as no one wants to step on the working capital landmine after investing countless hours in a deal.