United States

Working capital: The new negotiating tool


What a difference today's fast and furious M&A market makes. Deal volume is expected to top $3.7 trillion this year, the second biggest volume in history, according to Dealogic. Meanwhile, buyers, sellers and their advisors say working capital is being considered earlier in the deal process than ever before.

Indeed, buyers and sellers are using working capital as a new negotiating tool. "We've seen it move from something negotiated after the letter of intent…to becoming another element that buyers compete on as they are submitting their letters of intent," says Saurin Mehta, a managing director at the Chicago-based investment bank, Lincoln International. "It's another metric for which buyers need to compete."

Working capital, the funds needed to operate a business on a day-to-day basis, historically has been treated as an afterthought, an amount that the parties buying or selling companies leave to hammer out in the eleventh hour before a closing. That approach has often led to complications and delays or disputes that derail deals at the last minute and led to unwelcome changes in the purchase price.

Fundamentally a fairness mechanism

The working capital true-up is the difference between actual working capital at closing and the target working capital, resulting in a dollar-for-dollar true-up. If actual working capital is higher than the target working capital, the seller receives the difference. If actual working capital is less than the target, the buyer receives a refund. The working capital true-up is a significant economic factor in deals, and it demands attention.

To be sure, working capital agreements are sometimes misused as ammunition to push up or down the purchase price of a business. But done right, a working capital true-up is grounded in the understanding that a company being bought or sold should be delivered with a working capital level that's sufficient to support normalized levels or earnings of the business going forward. It's meant to encourage the seller to operate the business normally through the transaction and to protect the buyer from having to come out of pocket with extra money a few days after closing in order to keep the business running. "It's meant to serve as a fairness mechanism," says Mehta.

To realize this goal, both sides of the transaction need to be proactive about addressing the working capital issue early with their advisors. The complexities that need to be addressed were explored at a recent panel sponsored by RSM entitled, "Working capital: An art or a science?" Mehta along with panelists Walter Florence, a managing partner with the private equity firm Frontenac Company, and Kenneth Miller, a partner with the law firm of Katten Muchin Rosenman, note that the art of managing the working capital process varies greatly depending on the company being acquired.

William Spizman, an RSM partner who specializes in transaction advisory services, moderated the panel and maintains that the working capital process requires creativity as well as diligent attention to details from the beginning to the end of a transaction. He recalls the story of one business sold on Christmas Eve. As a result, unprocessed checks were left in a post office box over the holiday and the seller lost out on receiving the funds because the purchase agreement contained a working capital collar. "You can frame the best agreement with the best principles, but you also have to execute at closing," Spizman says. "Don't leave checks sitting in the post office mail box."


Consistency is the watchword on a number of working capital fronts. With the economy now in growth mode, many companies are being valued higher because there's an expectation that business is on the upswing. If this is the case, the working capital peg may need to be pushed up to support operating the business at that higher level. "Using working capital reflective of the past and not future operations isn't consistent," Mehta says. "Buyers will require a working capital level that is consistent with those future earnings."

Then, too, buyers and sellers need to be consistent when addressing accounting terms and assumptions related to such issues as bank overdrafts, capital lease obligations and net working capital. The purchase agreement may state that working capital should be defined in accordance with U.S. generally accepted accounting principles (GAAP) standards. Still, there is room for different interpretations within GAAP standards and those need to be addressed to avoid misunderstandings. "There's a lot of discretion in GAAP and you don't want different permitted policies in GAAP that may provide a situation where the buyer can play some games," says Miller, the attorney.

Miller also advises buyers to get an up-to-date accounting review of the business being purchased. That leads to a more predictable outcome, he said, because working capital is an accounting concept. In addition, the review will have the added bonus of helping to shine a light on the health of the business in question. "You can see whether they're a company that is teetering on the edge of insolvency," Miller said.

Keeping records to speed future resolutions

One of the main ways to smooth issues that come up later in the game is to make sure the agreements and documentations are there to protect both the buyer and seller. Many advisors say it's important that the agreements give stakeholders enough time to review the working capital calculation and give accountants and lawyers ample time to check out historical account records and documentation.

"You want to make sure you have a paper trail that demonstrated what people's intent was so you have something to go back to on the other side of the transaction," said Florence. Additionally, in case something does go awry, make sure the agreement provides for arbitration or mediation and avoids a trial by a judge or jury.

The full tank of gas

All this is designed to avoid tough problems that can snowball into unwieldy working capital disputes. One painful lesson of what is to be avoided was the case of an owner who sold his business but was faced with 32 adjustments at closing totaling $3.7 million. Spizman says ultimately the differences were whittled down to about a dozen before going to arbitration, but he emphasized the importance of taking action to avoid such headaches.

Starting the M&A deal on the right foot and making sure the buyer and the seller agree on a reasonable sale price for the business can go a long way to avoid working capital problems down the line. Buyers don't want to feel like they're buying a new car without a full tank of gas. "You don't want to buy a car and have to go down the street and put $50 bucks into it," Florence says. "You just don't feel good about that."


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Milton Marcotte
National Practice Leader