The working capital mechanism in an M&A purchase agreement exists to ensure the buyer receives the business with a "normal" level of operating liquidity at close. Getting it right requires a defensible peg based on normalized historical trends, a precise definition of which accounts are in and out, a measurement methodology the closing balance sheet will follow, and a dispute-resolution process both sides can live with. Most post-close disputes trace back to ambiguity in one of those four areas — and the time to resolve that ambiguity is before the SPA is signed, not after.
Enterprise value gets all the attention, but deal economics often turn on working capital. A $200 million transaction with a $2 million working capital miss in either direction is a 1% swing the parties will fight over for months. The working capital mechanism is the bridge between headline valuation and what the buyer actually pays — and unlike earnouts or holdbacks, it settles within 60 to 120 days of close, under time pressure, with money already in the seller's account.
The framework below covers the four areas that drive the most disputes: how to set the peg, what goes into the definition, how the true-up works mechanically, and the specific line items that reliably generate post-close disagreements.
What the working capital mechanism is doing
Most private-company M&A transactions in the U.S. use a completion mechanism: the purchase price is set on a cash-free, debt-free basis with a "normal" level of working capital. Enterprise value assumes the business arrives with enough current operating assets — receivables, inventory, prepaids — net of current operating liabilities — payables, accrued expenses, deferred revenue — to keep running without the buyer injecting additional cash on day one.
The target (or "peg") is the agreed-upon level of net working capital the business should have at close. If the closing balance sheet shows more working capital than the peg, the buyer pays the difference to the seller. If it shows less, the seller refunds. The mechanism is not about valuation — it's about ensuring the buyer receives the business in the operating condition the deal price assumed.
An alternative is the locked-box mechanism common in European and some cross-border deals, where the purchase price is fixed at a historical reference date with no post-close adjustment. The locked box avoids the true-up dispute entirely but shifts the risk to the buyer for any value leakage between signing and closing. Most U.S. middle-market transactions still use the completion mechanism, so the peg and true-up remain the default framework.
Setting the peg: what "normalized" actually means
The peg should represent the level of net working capital the business needs to operate under normal conditions — not a peak, not a trough, and not a period the seller has managed to look artificially clean. Getting this right requires three things.
A sufficient lookback period. Twelve months is the minimum; 24 months is better if the business is seasonal or has undergone significant growth. The goal is to capture a full operating cycle, including seasonal builds and unwinds in inventory or receivables. A business that ships 40% of its annual revenue in Q4 will have a very different working capital profile in October than in March — a single-quarter snapshot understates or overstates reality depending on when you look.
Normalizing adjustments. The raw monthly balances need to be adjusted for items that distort the run-rate: one-time transactions (a large customer prepayment that won't recur, an unusual vendor payment term negotiated for a single purchase), accounting-policy changes made in anticipation of the deal, related-party balances that will settle or disappear at close, and any reclassifications needed to align with the agreed working capital definition. The quality of earnings report typically does this work — and if it doesn't, the peg will be built on noise.
A methodology both sides agree on in advance. Average of trailing twelve months is the most common approach and generally the most defensible, because it smooths seasonality. Median of the trailing twelve months is sometimes used to exclude outlier months. A single-month or single-quarter snapshot is almost always a bad idea — it invites cherry-picking and doesn't reflect the cyclicality of most businesses. Whatever the methodology, it should be stated explicitly in the SPA and should match the accounting policies the closing balance sheet will follow.
Defining what's in and what's out
The working capital definition in the purchase agreement determines which balance sheet accounts are included in the calculation. This is where most of the negotiation happens — and where most post-close disputes originate.
The starting point is usually current assets minus current liabilities, excluding cash and cash equivalents, current portions of funded debt, and the current portion of any seller transaction expenses. Beyond that, nearly everything is negotiable, and the details matter more than the headline.
Accrued bonuses and variable compensation. Are they in or out? If the seller typically pays annual bonuses in Q1 for the prior year, the accrual at a mid-year close represents a real liability the buyer inherits. Leaving it out inflates working capital and effectively shifts the bonus cost to the buyer. Putting it in reduces the peg and provides a dollar-for-dollar offset. The answer depends on how the deal is structured — but the question must be addressed explicitly.
Deferred revenue. For businesses with subscription or contract-based models, deferred revenue can be the largest current liability. Including it in working capital means the peg absorbs the seasonal build and unwind of prepaid contracts. Excluding it typically benefits the seller, because a growing business with increasing deferred revenue will show a lower (more negative) working capital figure over time. The negotiation usually hinges on whether the deferred revenue represents a genuine future performance obligation or is economically closer to a prepayment with minimal remaining delivery cost.
Income tax receivables and payables. These are often excluded because they relate to the seller's tax position, not to ongoing operations. But state income tax payables, sales tax liabilities, and payroll tax accruals that the buyer will inherit are legitimately operational — and should either be included in working capital or addressed as a separate indemnity.
Intercompany balances. If the target is a subsidiary or carve-out, intercompany receivables and payables must be settled or excluded at close. Failing to address them in the definition creates a phantom asset or liability in the closing balance sheet.
The true-up: timing, measurement, and dispute resolution
The true-up process is straightforward in concept — prepare a closing balance sheet, calculate net working capital per the agreed definition, compare to the peg, and settle the difference — but the mechanics matter.
The closing balance sheet is typically prepared by the buyer within 60 to 90 days of close, using the accounting policies specified in the SPA (usually the target's historical GAAP policies, consistently applied). The seller then has a review period — usually 30 to 45 days — to object to specific line items. If the parties can't resolve disagreements, the dispute goes to an independent accounting firm acting as an arbitrator.
Three procedural points cause the most friction. First, the SPA should specify which GAAP policies govern the closing balance sheet and whether the buyer can change accounting estimates. A common source of disputes is the buyer applying more conservative reserve methodologies — higher inventory obsolescence, larger bad-debt allowances — that reduce working capital after the fact. The SPA language should require consistency with historical policies absent a material change in facts. Second, the scope of the independent accountant's review should be limited to the specific disputed items, not a full re-audit of the closing balance sheet. Broadening the scope turns a focused resolution into an open-ended engagement. Third, the independent accountant's determination should be binding and final, with the result falling within the range defined by each party's position — not an independent recalculation from scratch.
The five adjustments that generate the most post-close disputes
Inventory reserves. The buyer's operations team reviews inventory after close and concludes that obsolescence, slow-moving, or excess reserves should be higher than the seller's historical methodology. If the SPA doesn't lock in the reserve methodology, this is an easy $500K–$2M adjustment on a middle-market deal. The defense is a clearly stated reserve policy in the SPA's accounting-principles exhibit, with the independent accountant directed to apply that policy — not the buyer's preferred approach.
Accounts receivable collectibility. Similar dynamic. The buyer, now managing customer relationships, begins to form views on collectibility that differ from the seller's historical bad-debt methodology. Again, the SPA should specify the reserve methodology and the lookback period used to calculate it. Write-offs that occur after close based on post-close information are not valid true-up adjustments — the closing balance sheet should reflect facts and circumstances as of the close date.
Accrued liabilities completeness. The buyer identifies liabilities that weren't accrued at close — a vendor invoice that arrived late, a payroll true-up, an unrecorded sales tax liability. Whether these are valid working capital adjustments depends on whether they represent known conditions at close date. Seller counsel will argue they're indemnification claims, not working capital items. The line is fact-specific, but the SPA should define the standard: GAAP as consistently applied, with known or knowable conditions at close.
Revenue cutoff and deferred revenue. Revenue recognized in the last days before close — or deferred revenue that should have been recognized — can swing working capital materially. The buyer has an incentive to defer revenue recognition (reducing receivables, increasing deferred revenue, lowering working capital). The seller has the opposite incentive. A clean cutoff process, agreed upon before close, with dual-party involvement in the final days of the measurement period, is the best protection for both sides.
Prepaid expenses and deposits. Prepaids that won't benefit the buyer post-close — a seller-specific insurance policy, a prepaid conference sponsorship, a deposit on a lease the buyer won't assume — are often contested. The definition should specify whether prepaids are included at face value or only to the extent they provide future economic benefit to the buyer.
Preparation on both sides of the table
For sellers, the best working capital preparation starts 12 to 18 months before a process. Stabilize accounting policies — don't change reserve methodologies, revenue recognition practices, or accrual timing in the year before a deal. Clean up intercompany balances and related-party transactions. Ensure monthly closes are producing balance sheets that can withstand external scrutiny. The quality of earnings report the buyer commissions will anchor the peg negotiation, and a seller who can't explain its own working capital trends month over month has already lost leverage.
For buyers, the diligence work that matters most isn't the average — it's the volatility. A business with net working capital that swings $3 million across a twelve-month period on a $15 million peg has a fundamentally different risk profile than one that varies by $500K. Stress-test the peg against the month of expected close. Model the true-up exposure under pessimistic assumptions. And invest the legal fees to get the SPA's accounting-principles exhibit right — the $20K in incremental drafting time will save $200K in arbitration costs if the true-up is contested.
The working capital mechanism isn't where deals should create or destroy value. It's a calibration tool — and the deals that handle it well are the ones where both sides invested the time to agree on the rules before the clock started running.
Working capital disputes are rarely about bad faith. They're almost always about ambiguity — a definition that didn't address a material account, an accounting-principles exhibit that was copied from a prior deal without tailoring, or a peg methodology that didn't account for the business's actual seasonality. The fix is specificity, invested early. If you're preparing for a transaction — on either side — and want to pressure-test your working capital framework before it's locked into an SPA, we'd be glad to help.
This article is for general informational purposes and should not be relied on as accounting, tax, or legal advice for any specific transaction. Please consult with your advisors.