This is the most frequently misunderstood topic I have experienced, not just in M&A but across my entire career to date. Even M&A experts and veterans get confused.

If you're transacting in the M&A world, understanding Net Working Capital (NWC) and Purchase Price Adjustments (PPA) is a must that you can't afford to overlook.

In this comprehensive exploration, we'll delve into what Net Working Capital is, why it matters in M&A, and the mechanics of purchase price adjustment. By the end, you'll have a solid understanding of this complex but critical facet of deal-making and won’t get burned come the closing date.

Unraveling Net Working Capital (NWC)

Net Working Capital (NWC) is the measure of a company's liquidity and operational efficiency. Traditionally, as most of us have learned in our Academic careers, it is calculated by subtracting a company's current liabilities from its current assets. Current assets include items like cash, accounts receivable, and inventory, while current liabilities encompass short-term obligations such as accounts payable and accrued expenses. The resulting NWC figure indicates the amount of capital available for a company's day-to-day operations.

However, in the M&A world, NWC is actually a bit of a misnomer in that it differs from the traditional accounting definition. In M&A, most transactions occur on a “cash-free, debt-free” basis such that when a business is bought or sold, the resulting NWC transferred to the buyer does not include, cash, cash equivalents, debt, or debt-like items. So, NWC as evaluated in M&A is a slightly different version from the above definition.

The Role of NWC in M&A

In M&A transactions, NWC plays a vital role in the end price paid for a Company. It influences the purchase price, as a Buyer should receive enough working capital on day one post-transaction such that there are no changes in operations whatsoever. Not including NWC in a business transfer is said to be like buying a car with no tires, without it, the business just could not sustain operation properly without interruption. So, buyers include an amount of NWC in the offers, to make sure they can continue the operation. The only problem is, that you’re buying the business at a future date, and won’t be able to predict accurately how much net working capital and its components will look on the balance sheet as of the closing date.

Purchase Price Adjustment Mechanism

The Purchase price adjustment is a mechanism used to ensure that the final purchase price of the target company accurately reflects the NWC (and cash, and debt) at the time of the deal's completion. This adjustment is typically achieved through the following steps:

  1. Determining the Baseline NWC (the “peg”): Both the acquiring and target companies agree on a baseline NWC figure, which is often an average taken over a specific period leading up to the transaction. The calculation of this baseline serves as the reference point for NWC calculations.

  2. Calculating the Closing NWC: After a deal closes on the “true-up” date, a final NWC figure is calculated using the same methodology in Step 1. This figure reflects the company's NWC at the time of closing the transaction. So, why does this occur after closing? Because the business will not have complete accounting records as of the day of close and needs time to accurately record all transactions to that date before executing such an important calculation.

  3. Comparing to Baseline: The NWC as of the date of close is compared to the agreed-upon baseline NWC. If the closing NWC exceeds the baseline, the purchase price will be increased (the seller delivered more value than the baseline). Conversely, if the closing NWC is lower, the purchase price will be reduced (the seller delivered less value than the baseline). This is extremely important to understand and often surprises buyers.


Let’s take for instance you are buying the business and assuming all working capital is in place up-to-date, which occurs after closing. The purchase price is adjusted to a "normalized level or working capital equal to the average of the last twelve months." So this becomes your peg (benchmark amount of NWC) as negotiated.

So, to make it simple, if the average of the last 12 months is:

  • Accounts Receivable (AR) + Inventory + Other Current Assets (not including Cash since cash-free, debt-free) = 500k
  • Accounts Payable (AP) + Accruals + Other Current Liabilities (not including Debt since cash-free, debt-free) = 100k
  • Then your net working capital peg = 400k (500k less 100k)

Let's say your closing date is 12/31/23, and the balances true-up-to-date are:

  • Accounts Receivable (AR) + Inventory + Other Current Assets (not including Cash since cash-free, debt-free) = 450k
  • Accounts Payable (AP) + Accruals + Other Current Liabilities (not including Debt since cash-free, debt-free) = 150k
  • Then your net working capital received = 300k (450k less 150k)

In the above, because you received less than the peg at closing, your purchase price would be reduced by the difference of $100k ($400k vs $300k). If the opposite were to occur and the net working capital received is above the peg, the inverse occurs where you pay for the extra amount of NWC delivered.

The Significance of Purchase Price Adjustment

So, why this confusing mechanism? This protects the buyer from the seller manipulating the balance sheet by trying to funnel cash out of the business or running up liabilities during the long timeline of a deal. Thus, the purchase price adjustment has the following benefits:

  • Fair Valuation: It ensures that the purchase price accurately reflects the target company's financial position at the time of the transaction, preventing over- or underpayment.

  • Risk Mitigation: It reduces the risk of disputes between the acquiring and target companies by establishing a clear process for adjustments.

  • Sustaining Operations: It guarantees that the acquired business has sufficient working capital to continue its operations post-acquisition.

An important note, some M&A transactions occur without this purchase price adjustment as it can cause confusion, especially if non-M&A professionals (namely, lawyers) are involved. But, without this mechanism, the buyer and seller are both exposed to risks of the net working capital held in the business significantly fluctuating between the time of closing. A Purchase price adjustment, based on NWC, ensures that the final purchase price aligns with the target company's financial health at the time of the deal's closure. This intricate mechanism may seem complex, but it is an essential component of fair and effective M&A negotiations, ultimately benefiting both the acquiring and target companies.

Bottom Line

Net Working Capital holds great significance in M&A transactions because it can affect the amount of funds a buyer needs to come to the table with and how much a seller will receive. Negotiating a buyer-friendly or seller-friendly peg can equate to hundreds of thousands (and even millions) of dollars, drastically changing purchase prices. It is often one of the greatest sources of friction in an M&A transaction and is definitely the most misunderstood aspect. Understanding NWC and purchase price adjustment is a vital step toward making informed decisions in the world of mergers and acquisitions.

Please contact Petracca Group, experts in determining the NWC, and the peg, and help you navigate this complex topic.