TLDR:
A working capital adjustment is a post-closing price adjustment mechanism in M&A transactions that trues up the purchase price based on the actual working capital of the target company at closing compared to an agreed target. It ensures the buyer receives the business with a normalized level of operating capital and prevents seller manipulation of working capital around closing.
The Mechanism
The agreement specifies a Target Working Capital amount (typically based on historical averages over 12-24 months). At closing, the buyer pays the estimated purchase price. Within 30-90 days post-closing, the parties (or an independent accountant) calculate actual closing-date working capital. If actual exceeds target, the buyer pays the seller the difference; if actual falls below target, the seller refunds the difference to the buyer. Adjustments are typically dollar-for-dollar with no thresholds (unlike indemnification, which has baskets and caps).
Setting the Working Capital Target
Setting the target is highly contentious because it directly affects purchase price. Common approaches include: 12-month trailing average (most common), seasonally-adjusted average for businesses with seasonality, 24-month or 36-month longer averages for cyclical businesses, and median rather than mean to exclude outliers. The definition of “working capital” itself is heavily negotiated: typically current assets minus current liabilities, but with specific inclusions and exclusions (cash, debt, taxes payable, deferred revenue, intercompany accounts—each has implications). Sellers want loose definitions; buyers want strict definitions matching their post-closing operating needs.
Common Disputes
Working capital disputes are among the most common post-closing M&A litigation. Dispute triggers include: classification of items as working capital or otherwise (cash vs. restricted cash, accounts payable vs. debt-like items), application of accounting principles (GAAP/IFRS issues, consistency with historical practice), one-time vs. recurring items, treatment of accounting reserves and accruals, and the bring-down period (timing of measurement). Sophisticated agreements specify accounting principles precisely, name the independent accountant for dispute resolution, and limit the scope of disputes that go to expert determination. Locked-box mechanisms (fixed price agreed on a pre-signing balance sheet, no closing adjustment) are increasingly popular in European deals as alternatives to closing-account adjustments.