Working capital in a business sale
After the price itself, this clause costs sellers more than any other, and first drafts of the letter of intent often leave it out. Here is what it measures and how to set the target.
Working capital is the receivables, inventory and cash a business needs to operate, less its payables. Most offers assume a normal level, set as a target in the purchase agreement. If working capital at closing is below the target, the shortfall comes off the price dollar for dollar. Agree the target in the letter of intent, before exclusivity begins.
What working capital is
Working capital is the money a business needs on hand to run. It is the receivables owed to it, the inventory on the shelf and the cash in the account, less the payables it owes. A business with $400,000 of receivables, $150,000 of inventory and $200,000 of payables has $350,000 of working capital, and it needs roughly that much to keep operating on the day after closing.
Most offers for a business assume it comes with a normal amount of working capital. That assumption is where the money goes missing.
Why it moves the price
Take a price of $3 million on a cash free, debt free basis, meaning you keep the cash and pay off the debt, with a normal level of working capital. The buyer expects to find, on the day, the receivables and inventory the business usually carries. If they find less, they pay less, and the shortfall comes off the price dollar for dollar.
The reverse is also true, and sellers forget it. If the business has more working capital on the day than the target, the seller is owed the excess. Sellers who collect their receivables hard before closing to take the cash out are handing the buyer a shortfall and paying it back through the price.
The target, and how it is set
The purchase agreement sets a target: the normal level of working capital for this business. It is usually the average over the last twelve months, sometimes with seasonal adjustment, and the buyer proposes it during due diligence.
That timing is the problem. By diligence you are in exclusivity, with one buyer and little leverage, and a target set by the buyer will be set at the high end of the range. The place to set it is the letter of intent, as a figure or as a method, before you sign.
What gets argued about
- Which months. A twelve month average and a three month average are different numbers for a seasonal business. Ask for the period that matches the closing date. A business that stocked up ahead of the 2026 tariffs faces the same question.
- Old receivables. A buyer will want anything over 90 days excluded. If you have customers who always pay late and always pay, say so, with the evidence.
- Slow inventory. The same argument applies to stock. A buyer counts only the inventory it expects to sell within a year.
- Cash. Cash usually stays with the seller on a cash free basis. A business that needs a float to operate needs it on the day, and the target should say so.
- Accruals. These are amounts the business already owes, such as bonuses and vacation pay, along with deposits taken from customers. The buyer inherits them, so they count against working capital even when the seller left them out. A loan due within the year, such as a CEBA balance, counts as debt, so it belongs outside this figure.
The adjustment after closing
The actual working capital is measured on the closing date, usually by the buyer within 60 to 90 days, and compared to the target. The difference is paid one way or the other, often out of a holdback set aside for it.
The seller should have the right to review the calculation and dispute it, with any dispute decided by an independent accountant in place of the buyer’s own. The agreement should say how long each step takes. Those rights give you a say in the final figure.
A worked example
Take, as an illustration, a business sold for $3 million with a working capital target of $350,000.
| Item | Amount |
|---|---|
| Price, cash free and debt free | $3,000,000 |
| Working capital target in the agreement | $350,000 |
| Actual working capital at closing | $290,000 |
| Shortfall, deducted from the price | $60,000 |
| Received by the seller | $2,940,000 |
The $60,000 in this illustration is a seller who collected receivables in the last month and let the shelves run down, which is what an owner does when they are leaving. Both actions moved cash from the business to the seller, and both were paid back through the price.
What to do about it
- 01Know your own number. Have your accountant calculate monthly working capital for the last two years, so you know the range and the seasonality before anyone proposes a target.
- 02Put the target, or the method for setting it, in the letter of intent.
- 03Run the business normally through to closing. Collect and stock as you always have.
- 04Make sure the agreement gives you the right to review the closing calculation and a way to dispute it.
- 05Run the offer through the net proceeds tool, which shows the holdback and what lands in your account at closing.
This piece describes the working capital adjustment in general terms. The definition in your purchase agreement governs, and your accountant should read it before you sign.
Questions owners ask
- What is a working capital adjustment in a business sale?
- It compares the working capital in the business on the closing date against a target set in the purchase agreement, usually the twelve month average. A shortfall is deducted from the price and an excess is paid to the seller, typically within 60 to 90 days of closing.
- Does cash free, debt free include working capital?
- Cash free, debt free means the seller keeps the cash and pays off the debt. The business still has to come with a normal level of working capital. Receivables and inventory count as working capital, so a seller who collects them hard before closing to take the money out pays it back through the adjustment.
- When should the working capital target be set?
- Set it in the letter of intent, as a figure or a method. Left for diligence, it is proposed by the buyer while the seller is in exclusivity with one buyer, and it tends to land at the high end of the range.