Below is an excerpt from our e-book, “Start Here: An Insider’s Guide to Selling Your Business.”

A deal can always hit a bump, even if the end is in sight. When that happens, the Working Capital Adjustment can be the culprit. Here’s why:

• It’s usually addressed late in the game
• Hundreds of thousands of dollars (or more) can be at stake
• Business owners don’t always understand what it is, or how to address it
• It can be open to interpretation

Let’s back up: what’s working capital?

Working capital is the amount of operating liquidity available to a business at a certain point in time. Businesses need to have working capital to operate. Let’s start with the textbook definition of working capital:

current assets – current liabilities = working capital

Current assets are those items that are readily expected to turn into cash, or to be sold or exchanged during the next 12 months. So, in addition to the cash on the balance sheet, current assets would also include Accounts Receivable (“A/R”), Inventory and Prepaid Expenses.

Current Liabilities are those items that must be paid or “discharged” during the next 12 months, such as Accounts Payable (“A/P”) and Accrued Expenses (things like payroll, vacation, property taxes, etc.). These accruals need to be accounted for even if a Company does not typically book them.

However, in the context of a transaction, the seller typically keeps the cash but must pay off any debt or capitalized leases. In financial speak, this means the buyer is making an acquisition of stock or assets on a cash-free, debt-free basis. After eliminating cash and debt/capitalized leases from the calculation, there are typically four balance sheet accounts that primarily contribute to working capital: A/R, inventory, A/P, and accrued expenses.

Okay, so how does working capital impact a deal?

A buyer typically buys all the assets that generate the cash flow, including working capital. The buyer wants to make sure that on the day of closing, there’s enough working capital to keep the business running. And theoretically, a seller could manipulate the working capital accounts in an attempt to increase the cash that he’s entitled to when he sells the business.

For example: in the weeks before closing, the seller could stop replenishing inventory. This would increase the amount of cash at closing, and the seller would pocket more money. However, the buyer would then have to purchase new inventory, which effectively increases the price he is paying for the business.

Conversely, prior to closing, the seller could be spending a good deal of money on inventory that will be used to make sales post-transaction for the benefit of the buyer. This outlay of capital may reduce cash or increase Accounts Payable above normal levels. Without a Working Capital Adjustment, this could be detrimental to the seller.

Working Capital Target and Adjustment

To protect both buyer and seller from any swings in working capital, we use a “Working Capital Target.” It’s intended to ensure that the business is run in ordinary course and that there’s sufficient working capital at closing.

The Working Capital Target is a fixed dollar amount based on historical levels of working capital in the company. Both seller and buyer agree to it, and it’s included it in the Purchase Agreement. After closing, if net working capital exceeds the agreed-upon Working Capital Target, the seller is owed the difference in a cash payment. If net working capital is below the Target, then the seller owes the difference to the buyer. This adjustment is called the Working Capital Adjustment.

It’s not an exact science — and therein lies the problem: subjectivity can jeopardize a transaction. So, nailing down the Working Capital Target takes expertise and experience and some good old-fashioned negotiation. The goal is to land on a number that’s fair to both seller and buyer, and to keep the train on the tracks. Ultimately, the Working Capital Adjustment shouldn’t be a windfall to either party — or be a way to extract value.