A strong offer can lose value between signing and settlement if the business is delivered without the working capital a buyer reasonably expects. This guide to working capital adjustments explains how the mechanism works, where sellers are most exposed, and what to prepare before negotiations begin.
For an owner selling a small or medium-sized business, this is not a technical detail to leave until the lawyers are drafting documents. A working capital adjustment can move the final cash received by tens or hundreds of thousands of dollars. It can also become the point of friction that delays settlement, damages trust with a preferred buyer, or causes a deal to unravel.
What a working capital adjustment is
Working capital is the money tied up in the normal operating cycle of a business. In its simplest form, it is current operating assets less current operating liabilities. For many businesses, that means trade debtors plus stock and work in progress, less trade creditors and accrued operating expenses.
The adjustment is designed to ensure the buyer receives a business with a normal, usable level of working capital at settlement. The agreed enterprise value may assume that the business has enough stock to trade, receivables that are collectible, and creditors that reflect ordinary trading activity. If the actual working capital delivered is below that agreed level, the purchase price is reduced. If it is above the agreed level, the price may increase.
This distinction matters because a seller could otherwise improve their own cash position before settlement by running down stock, pushing creditor payments out, collecting debtors aggressively, or asking customers for deposits. Those actions may leave the buyer owning a business that needs an immediate injection of cash to keep operating.
The mechanism is usually used in a cash-free, debt-free transaction. The seller keeps surplus cash and settles debt, while the buyer pays an enterprise value subject to a normalised working capital position. But every deal is negotiated individually. Some smaller transactions use a fixed price with limited adjustments because the parties want simplicity. That can work where records are clean, trading is stable, and the agreed price clearly reflects the expected balance sheet position.
The working capital target, or peg
The central issue is the working capital target, often called the peg. It represents the level of working capital the business should have at settlement for normal operations to continue without disruption.
A credible peg is not simply the current month-end balance. It should be based on historical trading patterns and adjusted for seasonality, growth, unusual events, and changes in business practice. A construction business with significant progress claims, a tourism operator preparing for peak season, and a wholesaler building inventory before a major sales period will each need a different analysis.
A common starting point is an average of monthly working capital balances over the previous 12 months. That is useful, but averages can mislead. If a retailer carries unusually high stock in October and November before the Christmas period, an annual average may understate what is needed for a December settlement. If a business has grown rapidly, an older 12-month average may also be too low for its current trading scale.
The right question is practical: what level of stock, debtors, creditor funding and other operating balances does the buyer need on day one to run the business as represented?
What belongs in the calculation
The definition of working capital needs to be precise. Broad labels create disputes. The sale agreement should identify the included accounts, the accounting policies used to value them, and the treatment of items that sit near the line between operating and financing balances.
Items commonly included are trade receivables, inventory, work in progress, prepayments that benefit ongoing operations, trade payables, accrued wages, payroll liabilities, customer deposits, and accrued operating expenses. The exact mix depends on the business.
Cash, bank overdrafts, shareholder loans, tax liabilities, finance leases, related-party balances and debt are often excluded, but not always. Earned but unbilled revenue, retention receivables, aged stock, gift card liabilities, employee leave provisions and deposits can be material in particular sectors. A buyer and seller may take different views on each item, so assumptions should be tested early rather than argued after the commercial terms are agreed.
How the adjustment affects your sale proceeds
Assume a buyer agrees an enterprise value of $4.0 million and the parties set a working capital peg of $500,000. At settlement, the completion accounts show included current assets of $1.05 million and included current liabilities of $620,000. Actual working capital is therefore $430,000.
The business is $70,000 below the peg. Subject to the sale agreement, the buyer’s price is reduced by $70,000. If actual working capital were $570,000, the seller would receive an additional $70,000.
The calculation appears straightforward. The commercial difficulty lies in whether the $1.05 million of assets is realisable at the stated value, whether liabilities are complete, and whether the accounting treatment follows the agreed rules. A debtor that is seriously overdue, obsolete inventory in the warehouse, or an unrecorded supplier invoice can quickly change the result.
For this reason, sellers should not regard the adjustment as an opportunity to maximise a favourable closing balance. The objective is to deliver normal trading capital. Artificially inflating receivables or delaying legitimate expenses may produce a larger figure at settlement, but it raises the risk of a dispute, indemnity claim, or a difficult transition with the buyer.
Guide to working capital adjustments before you sign
The best time to resolve working capital is during sale preparation, not in the final week before settlement. A buyer conducting serious due diligence will test the cash conversion cycle, debtor ageing, stock movement, margin trends and supplier terms. If your records cannot explain movements, the buyer will either seek a lower price, demand wider protections, or lose confidence.
Start with monthly balance sheets for at least the past 12 months, and preferably 24 months where seasonality or project timing is significant. Reconcile debtors and creditors to supporting schedules. Review inventory counts and ageing reports. Identify slow-moving stock, doubtful debts, unusual customer deposits, unbilled work, related-party transactions and one-off accruals.
Then normalise the data. Remove balances that will not transfer with the business and identify items that were recorded inconsistently from month to month. If the owner has historically paid some expenses personally, if wages are accrued irregularly, or if stock is recorded only at year-end, correct the process before a buyer sees the information.
A sell-side due diligence process is particularly valuable here. It allows the seller to find weaknesses first, quantify them, and decide whether to remedy them or disclose them with a clear explanation. That protects negotiating leverage. It is far better to explain why one month’s stock level was unusual than to have a buyer uncover it and question every balance sheet figure.
Agree the rules, not just the number
A peg without a detailed calculation methodology is an invitation to a completion dispute. The sale documentation should set out the accounts included, the treatment of GST and other taxes where relevant, valuation methods for stock, provisioning policies for debtors, cut-off rules for revenue and expenses, and the timetable for preparing and challenging completion accounts.
Consistency is usually the governing principle. If inventory has historically been valued at the lower of cost and net realisable value, a seller should not adopt a more generous method at settlement. Equally, a buyer should not introduce new provisions that were never part of the business’s ordinary accounts simply to reduce the price.
There is also a trade-off between precision and cost. A highly detailed mechanism can be appropriate for a larger transaction, a project-based business, or a business with volatile working capital. For a stable service business with limited stock and short debtor days, a simpler approach may be commercially sensible. The key is that both parties understand the exposure before signing.
Common seller mistakes
The most expensive mistake is treating the peg as an accountant’s exercise rather than a sale-price issue. Working capital affects the cash you receive, the buyer’s confidence, and the operational handover.
Other recurring problems include allowing debtor ageing to deteriorate during the sale process, failing to conduct reliable stocktakes, paying suppliers outside normal terms to make the balance sheet look tidy, and ignoring accrued liabilities until completion accounts are prepared. Owners also underestimate how quickly seasonality can change the calculation. A settlement date moved by four weeks can materially alter stock, receivables, deposits and creditor balances.
Do not assume that a high working capital balance is automatically good news. Excess stock may be obsolete. A large debtor ledger may reflect collection problems. A low creditor balance may mean the seller has paid bills earlier than normal and effectively funded the buyer’s opening cash position. Quality matters as much as quantity.
Prepare for settlement with control
Once heads of agreement are signed, maintain ordinary-course trading. Keep collecting debtors, buying stock, paying creditors and accruing expenses in line with established practice. Monitor working capital against the peg each month, then weekly as settlement approaches. If a material variance appears, understand it immediately and communicate it through the agreed transaction process.
For owners planning an exit, working capital discipline should begin well before the business is marketed. Clean management accounts, reliable monthly reconciliations, sensible credit control and documented stock procedures do more than reduce completion risk. They demonstrate that the company is capable of operating without the owner making judgement calls from memory.
Tava’s sale-readiness work treats these issues as part of value protection, not last-minute paperwork. A business that can explain its financial position clearly gives the right buyer greater confidence in both the price and the transition.
Before accepting an offer, ask one final commercial question: if you were buying this business, would the working capital being delivered genuinely allow you to trade as expected from the first day? If the answer is not clear, resolve it before the transaction documents make uncertainty expensive.
