You agree a headline price. Then, sixty days after closing, a spreadsheet arrives from the buyer proposing that you owe them $840,000. Nobody misled you. You simply signed a definitive agreement containing a net working capital adjustment you never modeled.
This happens constantly in the lower middle market, and it is entirely avoidable. What follows is how the mechanism works, where the money actually moves, and what we do with owners twelve to eighteen months before a process starts.
What the adjustment is for
When a buyer prices your business, they are buying a going concern, a company that can pay its suppliers on Monday and collect from its customers on Friday without an injection of cash. The working capital adjustment exists to make sure the business arrives with a normal amount of that operating fuel in the tank.
The mechanic is straightforward in principle. The parties agree a target (often called the peg) representing normalized net working capital. At closing, actual net working capital is estimated. Ninety days later, the real figure is determined. If you delivered more than the target, the buyer pays you the difference. If you delivered less, you pay them.
Dollar for dollar. No multiple applied. Which is why it is worth your attention: this is the one number in the deal that flows straight through to your proceeds without being discounted or negotiated at the same intensity as EBITDA.
How the target gets set, and why the average matters
The market convention is a trailing twelve-month average of monthly net working capital, calculated on a defined basis and excluding cash and debt. That last exclusion matters. In most transactions this is a cash-free, debt-free deal: you keep the cash, you settle the debt, and working capital is measured on everything in between.
Two consequences follow, and neither is intuitive.
First, a twelve-month average buries seasonality. If your business builds inventory in Q3 to sell in Q4, your working capital requirement in September looks nothing like February. Close in a month when your actual working capital sits well below the annual average and you will write a check at settlement, not because anything went wrong, but because the measurement date fell in a trough.
Second, the twelve months being averaged are the twelve months you are living right now. Every month between today and the start of diligence is a month that will sit inside the calculation. Decisions you make this quarter set the peg you will be measured against.
Where owners actually lose money
In our experience the losses cluster in five places, and every one of them is a bookkeeping question rather than a negotiating question.
Receivables that were never real. A buyer will scrutinize the aging schedule and propose reserves against anything beyond ninety days. If your balance sheet carries $300,000 of invoices you privately know will never be collected, you have two options: reserve for them now and let the peg reflect economic reality, or hand the buyer a diligence finding they will use twice, once against the peg and once against your credibility.
Inventory that has not been counted. Obsolete stock, shrinkage nobody booked, work in progress valued on a basis that will not survive review. If your last physical count was eighteen months ago, the buyer’s count becomes the number of record.
Accrual discipline that comes and goes. This is the most common and the most expensive. If some months carry a full accrual for bonuses, commissions, or vacation and others do not, your monthly working capital series is noise rather than signal. A buyer looking at noisy data does not split the difference. They anchor to the months that favor them, and you have no clean basis to argue.
Deferred revenue treated casually. Customer deposits and prepayments are a liability. In a working capital calculation they reduce what you deliver. Companies that recognize revenue on receipt rather than on delivery arrive at diligence with a restatement waiting to happen.
Late-stage window dressing. Stretching payables in the final quarter, pushing hard on collections, deferring inventory purchases. Every buyer’s quality-of-earnings provider looks specifically for this, and finding it costs you far more in trust than the manoeuvre gains in dollars.
What preparation actually looks like
The work is unglamorous and it takes time, which is why it has to start well before a banker is engaged.
Build the monthly series and keep it. Net working capital, calculated the same way, every month, on a schedule you can hand to a buyer. Thirty-six months is better than twelve. When you can show a consistent methodology applied over three years, you control the conversation about what normal means.
Close properly and close on time. A hard monthly close with full accruals is the foundation of everything else. Without it there is no reliable series, and without a reliable series you are negotiating from the buyer’s data.
Clean the balance sheet early. Write off what is uncollectible. Count the inventory and reserve against what is dead. Do it eighteen months out, when it reads as good housekeeping rather than as a concession extracted under pressure.
Model your own seasonality. Know which months work in your favor and which do not. Deal timing is rarely fully within your control, but it is often influenceable, and knowing the shape of your own curve is worth real money.
Decide your definitions before someone else does. Which accounts are in, which are out, how each is measured. Bring that schedule to the negotiation rather than reacting to the buyer’s version of it.
The point
Working capital is not a technicality to be handled by lawyers at the end. It is a priced term, settled in cash, determined largely by the quality of bookkeeping you maintained in the year before anyone made an offer.
Owners who prepare treat it as an operating discipline. Owners who do not treat it as a surprise. The difference regularly runs to seven figures, and it is decided long before the letter of intent.