What is working capital and why does it matter in M&A?

Full Explanation

Imagine acquiring a company that normally trades with £1M of inventory. If the seller runs stock down to £0.5M before completion, the buyer must fund the shortfall to trade normally; if stock has been built up to £2M, the buyer receives more than the business needs. In deals, working capital is usually defined to exclude cash and debt, which are adjusted for separately. Where the price is set by completion accounts, buyer and seller agree a normalised working capital target (the peg), and the purchase price is adjusted pound for pound for the difference between actual working capital at completion and the peg. If the target was £3M and actual is £4M, the purchase price increases by £1M, because the buyer receives £1M more working capital than the price assumed. Conversely, if actual is £2M, the price decreases by £1M. This working capital adjustment protects both sides from surprises. Under a locked box there is no adjustment after completion: working capital is priced from the locked box accounts when the price is agreed. Key working capital drivers: (1) Inventory (days inventory outstanding), (2) Accounts Receivable (days sales outstanding), (3) Accounts Payable (days payable outstanding). For sellers, understanding working capital adjustment mechanics is critical: working capital below the peg at completion reduces proceeds, and working capital above it increases them, so the definitions and the level of the peg matter as much as the headline price. For buyers, negotiating a realistic working capital target and applying it carefully at completion protects acquisition return expectations. After completion, the adjustment is settled through the completion accounts, often secured by a retention or escrow until the figures are agreed.

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