Working Capital Adjustment in M&A:
How the True-Up Actually Works

A working capital adjustment (also called a working capital true-up or net working capital adjustment) is a post-closing mechanism that adjusts the purchase price based on the actual net working capital delivered at closing compared to a target amount negotiated in the purchase agreement. Net working capital is generally defined as current assets (accounts receivable, inventory, prepaid expenses) minus current liabilities (accounts payable, accrued expenses, deferred revenue). If the seller delivers more working capital than the target, the buyer pays more; if less, the buyer pays less. The adjustment ensures the buyer receives a business with the expected operating liquidity, not a business that has been stripped of cash or working capital by the seller.

A locked box is a European-origin alternative that fixes the economic effective date of the deal to a historical balance sheet (the 'locked box date') rather than closing. From the locked box date to closing, the seller cannot extract value from the business beyond ordinary-course management fees and dividends agreed in advance. The buyer takes the business as it was on the locked box date, with no post-closing true-up. Locked box structures are simpler - there is no post-closing calculation dispute - but they require the buyer to accept balance sheet risk from the locked box date to closing, and they require confidence in the locked box balance sheet's accuracy. They are common in European transactions and in deals where the parties want certainty and simplicity over precision.

The working capital target is typically set as the average net working capital of the business over a trailing period (often 12 months), intended to represent 'normal' operating levels. Both parties negotiate this target during the LOI or purchase agreement phase. Setting the target too high is in the buyer's interest (seller must deliver more); too low favors the seller. The definition of what is included in working capital - which assets and liabilities, how cash is treated, whether deferred revenue is included - is heavily negotiated and can have a significant impact on the adjustment. Sellers should engage their accountant and M&A counsel to model the impact of the proposed definition before agreeing to it.

After closing (typically within 60-90 days), the buyer prepares a closing statement calculating actual net working capital at closing using the accounting methods specified in the purchase agreement. The seller has a review period (typically 30-45 days) to object to the calculation. If the parties cannot agree, the disputed amount goes to a neutral accounting firm for resolution. The accountant's determination is typically final and binding. The adjustment is then paid: if closing NWC exceeded the target, the buyer pays the seller the difference; if below, the seller pays the buyer. Understanding this process before signing the purchase agreement is essential - it is one of the most common sources of post-closing disputes.

In a locked box structure, 'leakage' refers to value extracted from the business by the seller between the locked box date and closing that was not permitted under the locked box agreement. Permitted leakage typically includes agreed dividends and management fees. Unpermitted leakage includes transfers to related parties, unusual expenses, or asset disposals not at arm's length. The buyer has the right to recover unpermitted leakage from the seller post-closing, making the locked box concept cleaner in theory but still subject to verification in practice.