It took three months to close on a $140 million acquisition when the CFO of the company I acquired called me. We were doing a post-close working capital reconciliation, and the seller and I were at odds by $3.2 million. That was not the call you want to receive late on a Friday.

The root cause? How we defined and calculated net working capital. A simple reconciliation process turned into a six-month argument that burned through legal fees, strained relationships, and converted what felt like a smooth deal into something that created frustration for all parties involved.

During the next 18 months, I witnessed this same exact scenario occur in four more M&A transactions within our portfolio. Teams spent months discussing the purchase price, earnouts and reps & warranties. Then they tacked on a working capital clause (typically copied and pasted from prior agreements) in the final couple of weeks leading up to closing without considering the details.

Why working capital is ignored

Most people view acquisitions as a valuation exercise: What is the value of the business, and what am I willing to pay for it? All the stakeholders focus on the valuation questions. Working capital is viewed as “plumbing.” It is necessary but boring.

Working capital mechanisms are used to adjust the purchase price of the business based on the amount of working capital at closing versus the expected working capital at closing. This mechanism exists because a business’s cash position changes throughout the year. Therefore, the acquirer is purchasing the enterprise and not the business at a specific point in time.

The problem is not the concept of working capital; it is how it is executed. I have seen deals where the working capital target was established using 12 months of historical data, and yet the business was seasonal, and none of the participants accounted for it. I have also seen disputes over whether certain accruals should be included in the calculation of working capital. I have also seen disputes over what constitutes “business as usual” versus a one-time adjustment.

The biggest challenge is not the number itself, but the definition of terms that were agreed to months earlier. I have found three most problematic areas where disputes really occur:

1. Normalizing working capital:

The majority of purchase agreements define normal working capital as the trailing 12 months. If the seller managed cash aggressively prior to the sale, the target will not reflect the actual working capital requirements to operate the business. You essentially buy a business that requires more working capital than you valued in your pricing.

2. Deciding which items to include/exclude:

Simple accounting decisions with respect to cash, liabilities, deferred revenue and customer deposits can result in significant financial impacts.

3. Timing of measurement:

Deals typically close at month-end; however, working capital is finalized weeks later, after the company’s books are closed and audited. At this point, the parties are relying on estimates, cut-off determinations and professional judgments. If the purchase agreement does not provide guidance on how such estimates are to be made and who will bear the burden of any uncertainty related to those estimates, the parties are establishing grounds for a dispute.

A $2 million or $3 million dispute seems substantial, and it is. However, the higher cost of such disputes is the wear and tear on the parties involved in the deal. By the time working capital issues arise, the deal is closed. Integration has commenced. The new management team is trying to build momentum, and instead of driving growth, the parties are again in conference rooms debating accounting procedures and litigating definitions.

I have seen it destroy the relationship between buyer and seller who had previously enjoyed a strong relationship.

The irony is that most of these disputes can be avoided just by negotiating smarter and earlier.

The working capital formula

To avoid such drama, there were several commonalities between the deals I worked on:

1. Each party clearly defined its understanding of working capital from the start. In addition, each party was required to test those definitions based on the historical financial data and walk through potential edge case scenarios.

2. Each party was able to align its respective incentives. One of the deals I worked on created a working capital target in terms of a collar. A small variance either up or down did not result in an adjustment, while significant swings resulted in an adjustment. By creating this type of structure, the parties were no longer incentivized to “nickel-and-dime” each other on every accrual.

3. Finally, each party was able to establish a neutral third-party arbitration mechanism. The best purchase agreements I have seen provide for a clear, rapid dispute resolution mechanism that includes a named accounting firm that both parties agree to prior to closing. As a result, when a dispute arises, you do not need to spend time negotiating the rules of the game; you simply need to play by them.

In addition to the above three items, bringing your deal team and operating CFO into the discussions early-on also helps. While investment bankers and M&A attorneys are very good at structuring deals, it is typically your deal team and operating CFO who identify operational red flags that may not appear in a quality of earnings report.

The lesson I continue to learn about working capital is that it appears to be a minor detail until it is not. And once it is not, it is often too late. The deal is closed, the money has been transferred, and you are left to try to reverse engineer what “normal” should have been.

The deals that ultimately flow smoothly are not necessarily the ones with the most creative structures or the largest multiples. Instead, they are the deals where both parties actually agree on what they are buying and selling. And this agreement begins with the many details that everyone thinks they can determine later.

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