Purchase price gets most of the attention in a deal negotiation, but the working capital mechanism buried in the purchase agreement is where a surprising number of disputes actually erupt after closing. It’s worth understanding how it works before signing, not after.
Why Working Capital Gets Its Own Mechanism
Enterprise value is typically negotiated on a “cash-free, debt-free” basis, with the assumption that the business is delivered with a normal level of working capital to fund ongoing operations. Since working capital fluctuates seasonally and day to day, the purchase agreement sets a working capital target (the “peg”), usually based on a trailing average, and adjusts the final purchase price dollar-for-dollar based on the actual working capital delivered at close relative to that target.
Where Disputes Actually Start
- Vague definitions: If the purchase agreement doesn’t precisely define which line items count as working capital, and under which accounting policies they’re measured, both sides can walk into closing with different expectations of the true-up
- Inconsistent accounting policies: If the target’s historical average was computed under one set of policies (e.g. bad debt reserve methodology, inventory costing) and the closing statement is prepared differently, the comparison isn’t apples-to-apples
- Seasonality mismatches: A target with a seasonal business needs a target peg that reflects the specific closing date, not a simple trailing 12-month average that ignores where in the cycle the deal happens to close
- One-time items near the closing date: A large one-off receivable collection or unusual payables timing right before close can distort the closing statement in a way that doesn’t reflect normal operations
How Diligence Reduces This Risk
A well-run financial due diligence process analyzes historical working capital trends specifically to propose a defensible target peg before the purchase agreement is drafted — not to accept the seller’s proposed number at face value. This is also where quality of earnings work intersects with working capital: normalizing historical trends for one-time items and seasonality gives both sides a target that reflects how the business actually operates, reducing the odds of a dispute once the closing statement is delivered.
The Practical Takeaway
The working capital mechanism deserves the same scrutiny as the headline purchase price — because in practice, it’s often the term that determines whether the deal closes cleanly or ends up in a post-close arbitration over a few hundred thousand dollars. Getting the definitions, the target peg, and the accounting policies airtight before signing is far cheaper than resolving a dispute afterward.
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