When an agency is sold, the focus is often on big-picture terms — purchase price, deal structure, and transition plans. But a common clause that is often overlooked (and misunderstood) is the net working capital (NWC) adjustment. Both buyers and sellers need to understand how net working capital adjustments work, how targets are calculated, and what to watch out for when negotiating this part of a purchase agreement.
What Is Net Working Capital and Why Does It Matter?
Net working capital is typically defined as current assets minus current liabilities. In an agency setting, this usually includes accounts receivable, prepaid expenses, and work-in-progress, offset by accounts payable and accrued expenses. While cash is a current asset, it is often excluded in asset purchase transactions since a buyer doesn’t want to spend cash to buy cash.
When a buyer values a business, it is typically valued as an operating business. This means that the buyer assumes the business will continue paying bills, collecting receivables, and sending invoices after the closing. To avoid having to infuse a bunch of cash into the business at closing, the buyer assumes a normal level of working capital (receivables, prepaids, payables) will be in the business at the time of closing.
Recognizing that the components of working capital go up and down all the time, a NWC adjustment compensates for these fluctuations to ensure neither buyer or seller receive a windfall at closing due to timing differences. For example, if a seller were to collect all outstanding receivables and delay paying vendors before closing, without an NWC adjustment the buyer could inherit an operational cash crunch. In contrast, if a seller were to send out invoices right before closing and pay off all the bills right before closing, without a NWC adjustment, the buyer could receive a windfall in the form of high receivables. The NWC adjustment ensures the parties don’t have to worry about these timing effects.
How Target Working Capital Is Calculated?
Setting a fair target for working capital is a key part of negotiations. The most common approach is to base the target on an average of historical working capital levels, often looking at a trailing 12-month period. This helps smooth out seasonal fluctuations and one-off anomalies.
Buyers tend to prefer using recent NWC figures, especially if they show a downward trend, arguing that they best reflect the agency’s current financial condition. Sellers, on the other hand, often push for a longer historical average, ensuring they aren’t penalized for short-term fluctuations. Conducting a thorough due diligence process examining multiple years of historical financial information will help ensure a proper target is determined.
How the Working Capital Adjustment Clause Works
Once the target working capital is established, the calculation is fairly straightforward. Following closing, the books are properly closed and everything accounted for as of the closing date. If the NWC on hand at closing is greater than the target, the buyer pays the seller this excess. if NWC on hand at closing is less than the target, the buyer deducts this shortfall from what it owes on the purchase price.
To ensure any NWC shortfall doesn’t turn into a collection issue for the buyer, buyers often require a working capital holdback. This means that a portion of the purchase price is placed in escrow until the final NWC is determined. Then, if there is a shortfall (e.g., actual working capital at closing is less than target working capital), the buyer simply deducts that amount from the holdback and pays the balance of the holdback to seller. If there is NWC excess (e.g., actual working capital at closing is greater than the target working capital), the entire holdback is paid to the seller plus the excess amount. The true-up and holdback distribution is usually accounted for 90 – 120 days after closing.
Common Pitfalls and How to Avoid Them
One of the biggest mistakes in NWC adjustments is using an arbitrary target rather than a carefully calculated historical average. Buyers sometimes push for an overly aggressive NWC target to reduce the purchase price post-closing, while sellers may try to set the target too low to increase their immediate payout. A fair, data-driven approach should help avoid most disputes.
Another common issue is failing to define NWC components clearly. Agencies often have non-traditional working capital items, such as prepaid software licenses, deferred client billings, or large swings in accounts receivable due to project-based work. If these aren’t specifically addressed in the purchase agreement, they can create unexpected financial gaps. A good practice in these situations is to attach a schedule to the purchase calling out the components comprising NWC and how any shortfall or excess will be calculated.
A final pitfall is failing to use an NWC adjustment at all. Sometimes sellers instinctively think that they should retain all receivables since the work to produce those receivables was done prior to closing. This misunderstands how businesses are valued. An NWC adjustment ensures that all working capital components are treated as part of the income-earning “engine” of the business being acquired.
Conclusion
Net working capital adjustments may seem confusing at first, but they are important to understand as a buyer or a seller. NWC can have a major impact on final deal economics. Buyers want to ensure they receive a business that can function smoothly from day one, while sellers want to avoid unfair post-closing deductions from the purchase price. By carefully calculating target working capital, clearly defining included accounts, and structuring a fair holdback and true-up process, both parties can prevent disputes and ensure a smooth financial transition.
