{"id":26574,"date":"2023-08-09T08:14:34","date_gmt":"2023-08-09T13:14:34","guid":{"rendered":"https:\/\/breakingintowallstreet.com\/?post_type=biws_kb&#038;p=26574"},"modified":"2025-09-05T05:41:57","modified_gmt":"2025-09-05T10:41:57","slug":"working-capital-adjustment","status":"publish","type":"biws_kb","link":"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/working-capital-adjustment\/","title":{"rendered":"The Working Capital Adjustment in M&#038;A Deals and Leveraged Buyouts"},"content":{"rendered":"<div id=\"ez-toc-container\" class=\"ez-toc-v2_0_81 counter-flat ez-toc-counter ez-toc-grey ez-toc-container-direction\">\n<div class=\"ez-toc-title-container\">\n<p class=\"ez-toc-title\" style=\"cursor:inherit\">The Working Capital Adjustment in M&amp;A Deals and Leveraged Buyouts<\/p>\n<span class=\"ez-toc-title-toggle\"><\/span><\/div>\n<nav><ul class='ez-toc-list ez-toc-list-level-1 ' ><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-1\" href=\"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/working-capital-adjustment\/#Simple_Examples_of_the_Working_Capital_Adjustment\">Simple Examples of the Working Capital Adjustment<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-2\" href=\"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/working-capital-adjustment\/#Notes_and_Clarifications_About_the_Working_Capital_Adjustment\">Notes and Clarifications About the Working Capital Adjustment<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-3\" href=\"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/working-capital-adjustment\/#Model_Impact_of_the_Working_Capital_Adjustment\">Model Impact of the Working Capital Adjustment<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-4\" href=\"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/working-capital-adjustment\/#Working_Capital_Definitions_and_Targets\">Working Capital Definitions and Targets<\/a><\/li><\/ul><\/nav><\/div>\n\n<blockquote><p><strong>Working Capital Adjustment Definition:<\/strong> In an M&amp;A or LBO deal, the Working Capital Adjustment increases or decreases the Purchase Enterprise Value based on whether the seller is above or below its Working Capital Target at deal close; this adjustment keeps the <em>buyer\u2019s effective price<\/em> the same while changing the <em>proceeds to the selling shareholders<\/em>.<\/p><\/blockquote>\n<p>The Working Capital Adjustment is <strong>most common<\/strong> in acquisitions of private companies structured as <a href=\"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/cash-free-debt-free-basis\/\" target=\"_blank\" rel=\"noopener\">cash-free\/debt-free deals<\/a>.<\/p>\n<p>It incentivizes the management team to run the company normally without manipulating invoices, receivables, or inventory to increase its Cash balance artificially right before a deal closes.<\/p>\n<p>It also reduces the need for the buyer to provide additional funding to the seller on Day 1 following the deal close \u2013 assuming the management team has responded to these incentives.<\/p>\n<p>Here\u2019s the Excel file and slide presentation that illustrate the concept:<\/p>\n<p><a href=\"https:\/\/youtube-breakingintowallstreet-com.s3.us-east-1.amazonaws.com\/109-22-Working-Capital-Adjustment.xlsx\" target=\"_blank\" rel=\"noopener\">Simple LBO Model &#8211; Working Capital Adjustment (XL)<\/a><\/p>\n<p><a href=\"https:\/\/youtube-breakingintowallstreet-com.s3.us-east-1.amazonaws.com\/109-22-Working-Capital-Adjustment-Slides.pdf\" target=\"_blank\" rel=\"noopener\">The Working Capital Adjustment in Models- Slides (PDF)<\/a><\/p>\n<h3><strong>Video Table of Contents:<\/strong><\/h3>\n<p><strong>0:00:<\/strong> Introduction<\/p>\n<p><strong>6:14: <\/strong>Notes and Clarifications<\/p>\n<p><strong>6:59:<\/strong> Model Impact<\/p>\n<p><strong>8:10:<\/strong> Definitions and Targets<\/p>\n<p><strong>9:15:<\/strong> Recap and Summary<\/p>\n<h2><span class=\"ez-toc-section\" id=\"Simple_Examples_of_the_Working_Capital_Adjustment\"><\/span><strong>Simple Examples of the Working Capital Adjustment<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>Suppose that a buyer, such as a private equity firm, is paying a Purchase Enterprise Value of $600 (12x EBITDA) for a seller.<\/p>\n<p>The seller\u2019s Working Capital at deal close is $50, but the Working Capital Target in the deal is $100.<\/p>\n<p>In this case, the buyer reduces the <a href=\"https:\/\/breakingintowallstreet.com\/kb\/ma-and-merger-models\/ma-purchase-price\/\" target=\"_blank\" rel=\"noopener\">Purchase Enterprise Value<\/a> to $550, which results in only $500 of proceeds to the selling shareholders rather than $550 (assuming $50 of Cash and $100 of Debt):<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-26575 size-full\" title=\"Working Capital Adjustment for a Deficit\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074717\/01-Working-Capital-Adjustment-Deficit.jpg\" alt=\"Working Capital Adjustment for a Deficit\" width=\"1213\" height=\"693\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074717\/01-Working-Capital-Adjustment-Deficit.jpg 1213w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074717\/01-Working-Capital-Adjustment-Deficit-300x171.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074717\/01-Working-Capital-Adjustment-Deficit-1024x585.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074717\/01-Working-Capital-Adjustment-Deficit-768x439.jpg 768w\" sizes=\"(max-width: 1213px) 100vw, 1213px\" \/><\/p>\n<p>In the <a href=\"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/sources-and-uses\/\" target=\"_blank\" rel=\"noopener\">Sources &amp; Uses schedule<\/a>, the Uses side lists this \u201cAdjusted Purchase Enterprise Value\u201d and <strong>flips the sign of the Working Capital Adjustment<\/strong> so that it appears as a <em>positive $50<\/em> instead.<\/p>\n<p>It\u2019s a positive $50 because when the seller\u2019s Working Capital is below the targeted WC, the buyer needs to <strong>pay for additional Working Capital<\/strong> to bring it up to that targeted level!<\/p>\n<p>Here\u2019s the schedule:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-26576 size-full\" title=\"Working Capital Adjustment in the Sources &amp; Uses Schedule\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074716\/02-Working-Capital-Adjustment-Sources-Uses.jpg\" alt=\"Working Capital Adjustment in the Sources &amp; Uses Schedule\" width=\"1223\" height=\"441\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074716\/02-Working-Capital-Adjustment-Sources-Uses.jpg 1223w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074716\/02-Working-Capital-Adjustment-Sources-Uses-300x108.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074716\/02-Working-Capital-Adjustment-Sources-Uses-1024x369.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074716\/02-Working-Capital-Adjustment-Sources-Uses-768x277.jpg 768w\" sizes=\"(max-width: 1223px) 100vw, 1223px\" \/><\/p>\n<p>The buyer still pays the same effective price \u2013 $600 \u2013 but it\u2019s <strong>split<\/strong> into an Adjusted Purchase Enterprise Value of $550 and Additional WC Funding of $50.<\/p>\n<p>But the selling shareholders <strong>receive less<\/strong> \u2013 $500 rather than $550 \u2013 because they let the company\u2019s Working Capital fall below the target as the deal closed.<\/p>\n<p>The opposite happens if the seller\u2019s Working Capital is above the targeted WC level at the deal close \u2013 such as $150 vs. a target of $100.<\/p>\n<p>In this case, the Working Capital Adjustment <em>increases<\/em> the Purchase Enterprise Value to $650.<\/p>\n<p>The Purchase Equity Value is now $600, so the selling shareholders receive more:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-26577 size-full\" title=\"Working Capital Adjustment for a Surplus\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074715\/03-Working-Capital-Surplus.jpg\" alt=\"Working Capital Adjustment for a Surplus\" width=\"1211\" height=\"723\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074715\/03-Working-Capital-Surplus.jpg 1211w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074715\/03-Working-Capital-Surplus-300x179.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074715\/03-Working-Capital-Surplus-1024x611.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074715\/03-Working-Capital-Surplus-768x459.jpg 768w\" sizes=\"(max-width: 1211px) 100vw, 1211px\" \/><\/p>\n<p>In the Sources &amp; Uses schedule, the Adjusted Purchase Enterprise Value is $650, and the Working Capital Funding is ($50), so the effective price for the buyer is still $600:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-26578 size-full\" title=\"Working Capital Surplus in the Sources &amp; Uses Schedule\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074714\/04-Working-Capital-Surplus-Sources-Uses.jpg\" alt=\"Working Capital Surplus in the Sources &amp; Uses Schedule\" width=\"1214\" height=\"380\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074714\/04-Working-Capital-Surplus-Sources-Uses.jpg 1214w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074714\/04-Working-Capital-Surplus-Sources-Uses-300x94.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074714\/04-Working-Capital-Surplus-Sources-Uses-1024x321.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074714\/04-Working-Capital-Surplus-Sources-Uses-768x240.jpg 768w\" sizes=\"(max-width: 1214px) 100vw, 1214px\" \/><\/p>\n<p>These graphs sum up what happens due to the Working Capital Adjustment in deals:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-26579 size-full\" title=\"Summary of the Working Capital Adjustment in Different Scenarios\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074713\/05-Working-Capital-Scenarios.jpg\" alt=\"Summary of the Working Capital Adjustment in Different Scenarios\" width=\"1250\" height=\"733\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074713\/05-Working-Capital-Scenarios.jpg 1250w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074713\/05-Working-Capital-Scenarios-300x176.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074713\/05-Working-Capital-Scenarios-1024x600.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074713\/05-Working-Capital-Scenarios-768x450.jpg 768w\" sizes=\"(max-width: 1250px) 100vw, 1250px\" \/><\/p>\n<h2><span class=\"ez-toc-section\" id=\"Notes_and_Clarifications_About_the_Working_Capital_Adjustment\"><\/span><strong>Notes and Clarifications About the Working Capital Adjustment<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>Buyers set Working Capital targets in deals primarily to <strong>shift some of the risk to the sellers<\/strong>.<\/p>\n<p>For example, they don\u2019t want a seller to \u201cforget\u201d to pay its invoices right before an acquisition closes \u2013 delaying these payments would boost the seller\u2019s Accounts Payable and reduce its Working Capital.<\/p>\n<p>This is not fair for the buyer because it will need to pay these \u201cdelayed\u201d invoices after the deal closes, which means it needs to put additional money into the company.<\/p>\n<p>So, if this happens, the buyer reduces the Purchase Enterprise Value, as shown above, such that the Purchase Enterprise Value + Working Capital Funding equals the agreed-upon price ($600 in the examples above).<\/p>\n<p>The seller might also order insufficient Inventory or be very aggressive in collecting its receivables, which would increase its Cash and reduce its Working Capital.<\/p>\n<p>Again, buyers don\u2019t like this behavior because it creates the need for additional funding after the deal closes.<\/p>\n<p>So, they enforce the Working Capital Adjustment in deals to discourage this behavior and incentivize management to run the company normally.<\/p>\n<h2><span class=\"ez-toc-section\" id=\"Model_Impact_of_the_Working_Capital_Adjustment\"><\/span><strong>Model Impact of the Working Capital Adjustment<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>There is no real impact on the cash flows, exit, or <a href=\"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/how-to-calculate-irr-manually\/\" target=\"_blank\" rel=\"noopener\">IRR calculation<\/a> in a <a href=\"https:\/\/breakingintowallstreet.com\/kb\/ma-and-merger-models\/merger-model-walkthrough\/\" target=\"_blank\" rel=\"noopener\">merger model<\/a> or <a href=\"https:\/\/breakingintowallstreet.com\/kb\/leveraged-buyouts-and-lbo-models\/simple-lbo-model-excel\/\" target=\"_blank\" rel=\"noopener\">LBO model<\/a> <strong>because the buyer\u2019s effective price stays the same<\/strong> \u2013 and these models are always built from the buyer\u2019s perspective.<\/p>\n<p>In a 3-statement M&amp;A or LBO model, you record the Working Capital Adjustment somewhere on the post-transaction <a href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/balance-sheet\/\" target=\"_blank\" rel=\"noopener\">Balance Sheet<\/a>:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-26581 size-full\" title=\"Working Capital Funding in a Full 3-Statement LBO Model\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074712\/06-Working-Capital-Adjustment-3-Statement-Model-1.jpg\" alt=\"Working Capital Funding in a Full 3-Statement LBO Model\" width=\"1059\" height=\"660\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074712\/06-Working-Capital-Adjustment-3-Statement-Model-1.jpg 1059w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074712\/06-Working-Capital-Adjustment-3-Statement-Model-1-300x187.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074712\/06-Working-Capital-Adjustment-3-Statement-Model-1-1024x638.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2023\/08\/19074712\/06-Working-Capital-Adjustment-3-Statement-Model-1-768x479.jpg 768w\" sizes=\"(max-width: 1059px) 100vw, 1059px\" \/><\/p>\n<p>But this does not affect the <a href=\"https:\/\/breakingintowallstreet.com\/kb\/financial-statement-analysis\/change-in-working-capital\/\" target=\"_blank\" rel=\"noopener\">Change in Working Capital<\/a> in the forecasts, so the seller\u2019s cash flow remains the same, and so do metrics like the Exit Value and the IRR.<\/p>\n<p>In the simple model above, the Sources and Uses figures change slightly because the <strong>transaction fees<\/strong> change with a different Purchase Equity Value, but this is a <em>tiny<\/em> difference.<\/p>\n<h2><span class=\"ez-toc-section\" id=\"Working_Capital_Definitions_and_Targets\"><\/span><strong>Working Capital Definitions and Targets<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>You might also wonder how Working Capital is defined and how the \u201ctarget\u201d is set.<\/p>\n<p>There is no simple definition that works for all companies and industries, but Working Capital generally includes <strong>short-term, operational line items on the Balance Sheet<\/strong>, such as Accounts Receivable, Inventory, Prepaid Expenses, Accounts Payable, and <a href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/deferred-revenue\/\">Deferred Revenue<\/a>.<\/p>\n<p>You <strong>add<\/strong> the assets (Accounts Receivable, Inventory, and Prepaid Expenses) and <strong>subtract<\/strong> the liabilities (Accounts Payable and Deferred Revenue) to calculate Working Capital, as shown in the simple model above.<\/p>\n<p>But there are exceptions, such as Long-Term Deferred Revenue; also, some industry-specific line items, such as &#8220;Content Assets&#8221; for media companies, may also be included in Working Capital.<\/p>\n<p><strong>Notably, Cash and Debt are almost always excluded from Working Capital because these are not operational items \u2013 and in cash-free\/debt-free deals, they go to $0 and get replaced immediately after the deal closes.<\/strong><\/p>\n<p>The \u201cWorking Capital target\u201d is usually based on metrics such as Working Capital \/ Revenue over long periods or the company\u2019s cash collection and invoice payment policies.<\/p>\n<p>For example, if it has taken an average of 45 days to collect invoices from customers over the past 5-10 years, that might be used to estimate the company\u2019s required Working Capital based on its revenue level at the deal close.<\/p>\n<p>Many software-as-a-service (SaaS) companies have <strong><a href=\"https:\/\/breakingintowallstreet.com\/kb\/accounting\/negative-working-capital\/\">negative Working Capital<\/a><\/strong> due to high Deferred Revenue balances.<\/p>\n<p>In these cases, the buyer \u201cshould\u201d understand the problem with a positive Working Capital target and pick something more reasonable, such as a modestly negative number that reflects the company\u2019s cash collection and billing policies.<\/p>\n<p>However, \u201cshould\u201d is the operative word because many big companies do not properly understand this issue and will make it a negotiation point in deals.<\/p>\n<p>When this happens, you should run away and find another big company to acquire your firm \u2013 or point the buyer\u2019s acquisition team to this article.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>You&#8217;ll learn how the Working Capital Adjustment affects M&#038;A deals, leveraged buyouts, and financial models in this tutorial.<\/p>\n","protected":false},"featured_media":0,"template":"","class_list":["post-26574","biws_kb","type-biws_kb","status-publish","hentry","kb_category-leveraged-buyouts-and-lbo-models"],"acf":[],"_links":{"self":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb\/26574","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb"}],"about":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/types\/biws_kb"}],"wp:attachment":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media?parent=26574"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}