Working Capital as a purchase price trap in an acquisition

The enterprise value has been negotiated, the bottles of sparkling wine are ready – and then the final calculation arrives. Working capital adjustments often shift the final purchase price by six- or seven-figure amounts. Anyone who does not understand this mechanism ends up paying more – whether on the buyer’s or the seller’s side..

What working capital really means in an M&A context

Working capital – or net working capital – is simple in theory: current assets minus current liabilities. In an M&A context, however, things become significantly more complicated. The issue here is not merely whether a company is liquid, but how much operating capital is actually invested in the company on the closing date – and who pays for it.

The problem lies in the gap between the date of negotiation and the completion date. During this period, working capital can change significantly: receivables are collected, inventories are reduced and liabilities are extended. The amount paid by the buyer may then no longer correspond to what the buyer actually takes over.

The working capital mechanism: A purchase price formula with explosive potential

In practice, it works as follows: the buyer and seller first agree on an enterprise value – the total value of the company. The actual purchase price (equity value) is then determined according to the following basic logic:

Purchase price = Enterprise Value ± Working Capital variance ± Net Debt

A reference value (target working capital) is agreed for working capital – generally the average of the last 12 to 36 months, adjusted for exceptional items. If the actual working capital at closing is below this reference value, the purchase price falls. If it is above it, the purchase price rises.

That sounds fair. And it is – provided both parties understand the rules of the game. If they do not, costly surprises can arise.

Sellers should play an active role in shaping the target working capital before the buyer defines it. The first figure placed on the table establishes the anchor for all subsequent negotiations.

Three typical mistakes That prove costly for mid-sized companies

1. No or incorrect normalisation

The reference value should reflect “normal” working capital, adjusted for one-off effects such as extraordinary inventory build-ups for a special project, temporary payment terms or pandemic-related shifts. In practice, this normalisation is often missing or carried out only superficially. The result: an excessively high reference value disadvantages the seller, while an excessively low reference value disadvantages the buyer.

2. Unclear definitions in the purchase agreement

What actually counts as working capital? Do tax refund claims form part of it? Pension provisions? Advance payments made? These questions may sound technical, but they have a direct impact on the purchase price. Unclear definitions regularly lead to disputes during the closing accounts process – with legal costs and delays on top. In quite a few cases, the dispute ends up before an arbitral tribunal.

3. Seasonal fluctuations ignored

Many mid-sized industrial companies have highly seasonal working capital – high inventory levels in spring and low levels in autumn. If the reference value is calculated on the basis of a single reporting date rather than a rolling average, significant deviations may arise depending on the timing of closing. For the same business, a closing in March can produce a completely different result from a closing in October.

Buyer perspective: What you should check before signing

From a buyer’s perspective, working capital is an underestimated due diligence discipline. Typical warning signs in Financial Due Diligence FDD include:

• Unusually low liabilities shortly before closing: Did the seller pay suppliers early in order to reduce liabilities – at the buyer’s expense?
• Inflated receivables: High outstanding receivables can appear to increase working capital, but may be of poor quality if they are overdue or doubtful.
• Inventory reduction shortly before closing: If inventory levels fall noticeably in the weeks before signing, alarm bells should start ringing.

A proper FDD analyses not only the reporting date, but also working capital trends over at least 24 to 36 months – including a seasonality analysis and the effects of normalisation. This is the only way to derive a robust reference value that does not systematically disadvantage either the buyer or the seller.

Seller perspective: Lack of preparation means giving money back

For sellers, the working capital adjustment is often a blind spot – with sometimes painful consequences. The most common mistakes are:

• Addressing the mechanism too late: Anyone who only starts to understand their working capital at the LOI stage has already surrendered negotiating positions.
• No awareness of the reference value: Sellers accept reference values that are not representative of historical performance – for example, because an exceptional year has distorted the average.
• No preparation for the closing accounts: Preparing the closing balance sheets is often complex and negotiated with the buyer’s adviser. Anyone who enters this process without their own expertise is at a disadvantage.

Locked box vs closing accounts: Which model protects whom?

There is an alternative to the traditional closing accounts mechanism: the locked box model. Under this model, the purchase price is fixed on the basis of a specified historical reporting date, with no subsequent adjustments. For sellers, this provides planning certainty. For buyers, it means greater risk if capital leaves the business between the locked box date and closing (known as leakage).

	Closing Accounts	Locked Box
Purchase price adjustment	Yes, retrospectively on the basis of actual closing figures	No, fixed price as at the reporting date
Seller preference	Generally no (uncertainty until closing)	Yes (planning certainty)
Buyer preference	Generally yes (only pays for what it receives)	Generally no (risk of leakage)
Typical use	Mid-sized companies, complex structures	Private equity-driven transactions

What we specifically deliver in working capital analysis

In the area of working capital, our analysis specifically includes:

• Historical working capital analysis over at least 24–36 months, with normalisation of exceptional items.
• Seasonality analysis to determine a representative reference value.
• Definition and delineation of working capital items for the purchase agreement.
• Warning-sign screening: identifying unusual shifts shortly before signing.
• Support during the closing accounts process: assistance with the final purchase price calculation after completion.

In practice, we encounter the same three gaps in almost every Financial Due Diligence project for mid-sized companies: unclear delineation of items, a lack of normalisation of seasonal effects and inadequate documentation, which unnecessarily prolongs the closing accounts process.

If you do not know the reference value before negotiating, you will either pay it – or fail to get it back.

Frequently Asked Questions about Working Capital

What is a typical reference value for working capital?

In practice, a rolling 12- or 36-month average is often used, adjusted for exceptional items. Alternatively, the reference value can be set as a percentage of revenue – which is particularly useful for rapidly growing companies.

How large can working capital adjustments be in practice?

In mid-market transactions involving an enterprise value of €10–50 million, adjustments of €500,000 to several million euros are not uncommon – particularly for industrial and trading companies with significant amounts of capital tied up in inventory and receivables..

Do I really need a Financial Due Diligence if I know the company well?

Yes. Knowing the company does not necessarily mean that you will identify changes in working capital during the months leading up to closing. An FDD provides systematic transparency that personal judgement cannot replace.

What happens if the purchase agreement contains no working capital provision?

The buyer then bears the full risk. If there is no adjustment clause, the buyer can no longer claim a subsequent reduction in the purchase price on the grounds that working capital was too low.

How early should I address this as a seller?

Ideally, 12–18 months before the planned exit. This provides time to optimise working capital, document exceptional items and build a robust data basis for the negotiations.

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