Working Capital Adjustments in M&A: Protecting Value at Closing

Working capital adjustments are one of the most technically important -- and most frequently disputed -- elements of M&A transactions. They determine how much the buyer actually pays at closing by ensuring that the business is delivered with a "normal" level of operating working capital: not artificially inflated by deferred payments or accelerated collections, and not depleted by pre-closing cash extraction. Getting working capital right protects both buyer and seller from value transfer that was not intended when the purchase price was agreed.

Despite their importance, working capital adjustments are often poorly understood by deal participants. This guide provides a practitioner-level walkthrough of working capital mechanics in M&A, covering the conceptual foundation, the two primary mechanisms (completion accounts and locked box), the methodology for calculating normalised working capital, common disputes, and practical examples with numbers. For broader context on working capital in M&A transactions, see our earlier article on working capital adjustments in M&A transactions.

Why Working Capital Matters in M&A

When a buyer and seller agree on an enterprise value for a business -- say, EUR 100 million at 8x EBITDA -- they are implicitly assuming that the business will be delivered with a "normal" level of working capital. Working capital is the lifeblood of operations: it funds the gap between when a company pays its suppliers and when it collects from its customers. If the business is delivered with less working capital than normal, the buyer effectively receives a deficient asset and needs to inject additional cash to maintain operations. If it is delivered with excess working capital, the buyer receives a windfall.

The working capital adjustment mechanism ensures that the final purchase price reflects the actual working capital delivered at closing relative to the agreed target (the "peg" or "target" working capital). If closing working capital exceeds the peg, the purchase price is increased; if it falls below, the price is reduced. This mechanism is conceptually simple but can be technically complex in practice, particularly for businesses with seasonal patterns, long-term contracts, or unusual accrual policies.

The Enterprise Value Bridge

Understanding working capital adjustments requires understanding the "enterprise value to equity value bridge" -- the mechanism that converts the agreed enterprise value into the price the buyer actually pays for the equity of the company. The standard bridge works as follows:

• Starting Point: Agreed Enterprise Value (e.g., EUR 100 million)
• Plus: Excess cash (cash above the minimum required for operations)
• Minus: Financial debt (all interest-bearing obligations)
• Minus: Debt-like items (pension deficits, deferred tax liabilities, provisions, etc.)
• Plus/Minus: Working capital adjustment (closing WC vs target WC)
• Equals: Equity Value (the price paid for the shares)

This bridge is the cornerstone of deal pricing and is where most of the post-signing negotiation occurs. Each element -- net debt, debt-like items, and working capital -- can involve significant judgement and interpretation, which is why precise definitions in the purchase agreement are essential. For more on enterprise value calculations, see our guide on how to calculate enterprise value.

Completion Accounts vs Locked Box: Two Approaches

There are two fundamental approaches to handling the working capital adjustment (and the broader equity value bridge) in M&A transactions: completion accounts and locked box. The choice between them has significant implications for deal dynamics, risk allocation, and post-closing obligations.

Completion Accounts Mechanism

Under a completion accounts mechanism, the purchase price is calculated based on the actual financial position of the target at the closing date. The process typically works as follows:

• Estimated Price at Closing: The buyer pays an estimated purchase price at closing, based on the most recent available financial data and agreed-upon estimates of net debt and working capital.
• Completion Accounts Preparation: Within an agreed period after closing (typically 60-90 days), one party (usually the buyer) prepares draft completion accounts, which are a balance sheet and/or specific financial statements prepared as of the closing date, using agreed accounting policies.
• Review Period: The other party (usually the seller) reviews the draft completion accounts and raises objections within a specified period (typically 30-45 days).
• Dispute Resolution: If the parties cannot agree on the completion accounts, the disputed items are referred to an independent accountant (expert) for determination.
• True-Up Payment: Once the completion accounts are finalised, the difference between the estimated price and the actual price (based on final net debt and working capital) results in a true-up payment from one party to the other.

Completion accounts are more common in the US and in certain European jurisdictions (UK, Germany). They provide the buyer with the comfort of paying based on actual closing-date financials but create post-closing risk for the seller (the buyer controls the business post-closing and prepares the completion accounts).

Locked Box Mechanism

Under a locked box mechanism, the purchase price is fixed by reference to a historical balance sheet date (the "locked box date" or "effective date"), and no post-closing price adjustment occurs. The economic ownership transfers to the buyer on the locked box date (even though legal ownership transfers at closing), and the seller is prohibited from extracting value from the business between the locked box date and closing ("leakage").

• Fixed Price: The purchase price is agreed and fixed based on the balance sheet at the locked box date. There is no post-closing true-up for working capital or net debt.
• No Leakage Covenant: The seller covenants that no value has been (or will be) extracted from the target between the locked box date and closing. Prohibited leakage typically includes: dividends, management fees, intercompany loans, abnormal transactions, excessive compensation, and other transfers of value to the seller or its affiliates.
• Permitted Leakage: Certain items are agreed as permitted leakage (ordinary course dividends, pre-agreed bonuses, tax payments, etc.) and are either factored into the purchase price or explicitly carved out.
• Ticker / Per Diem Payment: To compensate the seller for the economic benefit that accrues to the buyer between the locked box date and closing (since the buyer receives the profit earned during this period), the buyer may pay a daily interest-like amount (the "ticker") calculated on the equity value from the locked box date to closing.

Locked box is the dominant mechanism in European M&A (particularly in the UK and Continental Europe), and is strongly preferred by PE sellers because it provides price certainty -- the seller knows exactly how much it will receive at closing, with no risk of post-closing true-up disputes.

Choosing Between the Two Mechanisms

The choice between completion accounts and locked box depends on several factors:

• Information Quality: Locked box works best when the seller's financial reporting is reliable and transparent, and the buyer has confidence in the locked box date balance sheet. If there are concerns about financial reporting quality, completion accounts provide more protection.
• Seasonality: Businesses with significant seasonal working capital patterns may be easier to handle with completion accounts (which capture the actual closing-date position) than with locked box (which fixes the price based on a potentially non-representative date).
• Time Between Signing and Closing: If there is a long gap between signing and closing (e.g., due to regulatory approvals), locked box exposes the buyer to greater leakage risk. The ticker mechanism and enhanced operating covenants can mitigate this, but completion accounts may be more appropriate for very long periods.
• Seller Power: PE sellers and auction processes tend to favour locked box because it provides price certainty and limits the buyer's ability to re-trade post-closing. Bilateral negotiations with a single buyer more often result in completion accounts.

Calculating Normalised Working Capital: The Peg

The normalised working capital (NWC) -- also called the working capital "peg" or "target" -- is the benchmark level of working capital that the buyer expects to receive at closing. Setting the peg is one of the most important and contentious elements of deal negotiation, because every dollar of difference between the peg and the actual closing working capital flows directly to the purchase price.

Step 1: Define Working Capital Components

The first step is to agree precisely which balance sheet items are included in the working capital calculation. A typical definition includes:

• Current Assets Included: Trade receivables, inventory, prepaid expenses, accrued income, other current assets (excluding cash and cash equivalents, which are captured in the net debt calculation).
• Current Liabilities Included: Trade payables, accrued expenses, deferred revenue, tax liabilities (operating taxes, not income tax), other current liabilities (excluding financial debt, which is captured in the net debt calculation).
• Excluded Items: Cash, financial debt, income tax payable/receivable, deferred tax, provisions for restructuring or litigation (typically treated as debt-like items).

Precise definition matters enormously. A EUR 500,000 receivable that is "in" or "out" of working capital directly affects the purchase price. The definitions should be agreed in the heads of terms / LOI stage and precisely documented in the purchase agreement, with an illustrative calculation attached as a schedule.

Step 2: Calculate Historical Monthly Working Capital

To determine the normalised level, you need historical working capital data on a monthly basis for at least the last 24 months (ideally 36 months). Monthly data captures seasonal patterns that quarterly or annual data would miss. For each month, calculate net working capital using the agreed definition. This produces a time series that reveals the business's working capital profile: its typical level, seasonal patterns, and any trends.

Step 3: Identify and Adjust for Anomalies

The historical data must be examined for anomalies that would distort the normalisation calculation:

• One-Time Items: Large receivables or payables related to non-recurring events (litigation settlements, insurance claims, one-off capital projects).
• Related-Party Balances: Intercompany receivables or payables with the seller or affiliates that will not exist post-closing.
• Timing Anomalies: Month-end cut-off effects where a large payment or receipt that straddles the month-end distorts the snapshot.
• Accounting Policy Changes: Changes in revenue recognition, provisioning, or other policies that affect the comparability of periods.
• Growth or Decline Effects: If the business is growing rapidly, historical average working capital may understate the normalised level because working capital needs increase with revenue. Conversely, a declining business may have inflated historical averages.

Step 4: Calculate the Peg

After adjustments, the peg is typically calculated as the average (or median) of the adjusted monthly working capital figures over the relevant period. Common approaches include:

• Simple Average: Average of the last 12 or 24 months. Simple and transparent but can be distorted by outliers or trends.
• Trailing 12-Month Average: The most recent 12 months, weighted equally. Captures the current operating profile but may be influenced by recent anomalies.
• Seasonal Average: For highly seasonal businesses, use the average of the same calendar month across multiple years (e.g., average December working capital over 3 years). This ensures the peg reflects the expected seasonal position at the likely closing date.
• NWC as % of Revenue: Express normalised working capital as a percentage of trailing revenue, then apply that percentage to projected revenue at the closing date. This is useful for growing businesses where absolute historical averages would understate the required level.

Common Working Capital Disputes

Working capital is the most frequently disputed area in M&A completion accounts. Understanding the common disputes helps you anticipate and prevent them through clear drafting and proactive negotiation.

1. Definition Disputes

The most common disputes arise from ambiguity in the definition of working capital items. Is a specific provision (e.g., a warranty reserve) a working capital item or a debt-like item? Is a long-term receivable included? What about deferred revenue that spans more than 12 months? The solution is precise, exhaustive definitions in the purchase agreement, with an illustrative example calculation that the parties agree on before signing.

2. Accounting Policy Disputes

Completion accounts are prepared using "consistent accounting policies" -- but consistent with what? The target's historical policies? GAAP/IFRS? A specific set of policies agreed in the SPA? Disagreements often arise when the buyer wants to apply more conservative accounting policies to the completion accounts than those used historically by the target. The SPA should specify the hierarchy of accounting policies (e.g., "in accordance with the accounting policies used in preparing the Last Accounts, consistently applied") and provide for resolution of any inconsistencies.

3. Seller Manipulation Before Closing

Sellers may be tempted to inflate working capital before closing by: accelerating customer invoicing (to inflate receivables), delaying supplier payments (to inflate payables), building excess inventory, or front-loading revenue recognition. These actions increase closing working capital and, under a completion accounts mechanism, increase the purchase price. The buyer's defences include: clear definitions of permitted and prohibited conduct in the SPA, operating covenants that restrict the seller's actions between signing and closing, the normalisation methodology (which adjusts for unusual patterns), and the right to challenge manipulated balances in the completion accounts process.

4. Cut-Off and Timing Disputes

Working capital is a snapshot at a specific moment in time, and even small timing differences can create large discrepancies. A EUR 2 million payment that arrives one day before vs one day after the closing date changes the working capital figure by EUR 2 million. These cut-off disputes are common and are best prevented by: clear rules in the SPA about the cut-off date and time, agreed procedures for handling receipts and payments around the closing date, and cooperation between buyer and seller finance teams during the completion accounts preparation process.

5. Peg Methodology Disputes

Even when parties agree on a methodology for calculating the peg, disputes can arise over: which months to include or exclude, how to handle outliers, whether to use average or median, whether to adjust for growth, and how to handle seasonal patterns. These disputes are most effectively prevented by agreeing on the methodology in detail during the SPA negotiation (not after closing) and by including a fully worked example calculation as an appendix to the SPA.

Practical Example: Full Working Capital Adjustment

Let us walk through a complete working capital adjustment to illustrate how the mechanics work in practice.

Transaction Setup

• Enterprise Value: EUR 80 million (8.0x EBITDA on EUR 10M normalised EBITDA)
• Mechanism: Completion accounts
• Target Working Capital (Peg): EUR 6.5 million (agreed as 12-month average of normalised NWC)
• Estimated closing net debt: EUR 12 million
• Estimated closing working capital: EUR 6.5 million
• Estimated equity value at closing: EUR 80M - EUR 12M + EUR 0M (WC at peg) = EUR 68 million

Actual Closing Position

• Actual closing net debt: EUR 13.2 million (EUR 1.2M more than estimated)
• Actual closing working capital: EUR 5.8 million (EUR 0.7M below peg)

True-Up Calculation

• Net debt adjustment: EUR 12.0M (estimated) - EUR 13.2M (actual) = -EUR 1.2M (price decreases)
• Working capital adjustment: EUR 5.8M (actual) - EUR 6.5M (peg) = -EUR 0.7M (price decreases)
• Total true-up: -EUR 1.9M
• Final equity value: EUR 68.0M - EUR 1.9M = EUR 66.1 million
• True-up payment: Seller pays EUR 1.9 million to buyer

Negotiation Strategies for Buyers and Sellers

Buyer Strategies

• Argue for a Lower Peg: Use the most recent months (if working capital has been declining) or exclude high-WC months as anomalies. A lower peg increases the probability of a downward adjustment at closing.
• Push for Completion Accounts: Completion accounts give the buyer control over the post-closing process and the ability to scrutinise the actual closing-date position.
• Insist on Monthly Granularity: Monthly data reveals seasonal patterns and anomalies that quarterly or annual data obscures. Better data leads to more accurate normalisation.
• Negotiate Tight Definitions: Ensure that debt-like items (provisions, deferred revenue, long-term liabilities) are excluded from working capital and captured in the net debt definition. Every item classified as "debt-like" rather than "working capital" reduces the peg and is excluded from the working capital true-up.
• Include a Collar or De Minimis: A collar (e.g., no adjustment for the first EUR 200K of deviation from peg) can reduce the administrative burden of small true-ups, but buyers should be cautious about wide collars that enable seller manipulation.

Seller Strategies

• Argue for a Higher Peg: Use a longer historical period (which may include higher-WC months) or argue that growing businesses need higher normalised working capital to support increased revenue.
• Push for Locked Box: Locked box eliminates post-closing uncertainty and prevents the buyer from using the completion accounts process to renegotiate the price. Most sell-side advisors recommend locked box for auction processes.
• Commission a VDD Working Capital Analysis: Having the working capital peg analysis prepared by the seller's VDD adviser provides a credible, independent basis for the peg and reduces the buyer's ability to argue for a different number. See our guide on M&A due diligence for context.
• Negotiate Consistent Policies: Ensure that the completion accounts are prepared using the same accounting policies used historically. This prevents the buyer from applying more conservative policies that would deflate working capital.
• Secure an Escrow: If using completion accounts, negotiate for a capped escrow (rather than a full true-up exposure) to limit the maximum downward adjustment the seller can face.

Conclusion

Working capital adjustments may lack the glamour of strategic rationale and valuation multiples, but they are where M&A transactions succeed or fail at the margin. A EUR 1-2 million working capital adjustment -- small relative to enterprise value but significant in absolute terms -- can easily determine whether a deal is value-accretive or value-destructive for the buyer, and whether the seller achieves their target proceeds.

The keys to getting working capital right are: precise definitions agreed early in the process, rigorous normalisation based on granular monthly data, clear agreement on the peg methodology, and tight SPA drafting that anticipates the common disputes. Both buyers and sellers should invest in experienced financial advisors who specialise in completion account mechanics and can navigate the technical complexities that inevitably arise.

Discover how Synergy AI can accelerate your M&A process. Our platform provides AI-powered financial analysis tools that help buyers and sellers calculate normalised working capital, identify anomalies, and prepare for completion account negotiations with data-driven confidence.