There is a version of a business acquisition that looks beautifully
simple on a spreadsheet.
The company makes $500,000 of normalized EBITDA.
The seller wants four times earnings.
Purchase price: $2 million.
I put in $500,000 of equity, finance the rest with some combination of
senior debt and a vendor take-back, close the deal, and own a company
producing half a million dollars a year.
Then someone asks a question that can quietly change the entire
transaction:
How much net working capital is included?
This is the kind of question that sounds like it belongs to the
accountants until the answer is $300,000.
Then it belongs to me.
Because the business may need $300,000 of receivables, inventory and
other operating current assets, net of its normal operating liabilities,
just to produce the EBITDA I am paying for. If that working capital does
not arrive with the business at closing, I have not really bought the
operating company represented in the financial statements.
I have bought most of it.
Then I need to write another cheque to make it work.
This is why net working capital — NWC — has become one of the
acquisition concepts I care about most. It sits in an awkward place
between valuation, cash flow, operations and legal drafting. It is easy
to overlook when the interesting conversations are about EBITDA
multiples, seller financing and how much debt a lender will provide.
But if I were putting together a letter of intent to buy a real
operating business, I would want the working-capital mechanism addressed
before I spent months on diligence.
Not after.
Not when the purchase agreement is almost finished.
And definitely not the week before closing.
I touched the issue in Digital Business vs Physical Business Acquisition
and in my deeper look at SDE vs EBITDA.
The reason it keeps appearing is that working capital is the bridge between
accounting profit and the cash actually required to operate a business.
A company can be profitable and still consume cash.
A company can grow and become more cash-starved.
And a debt-free company can accumulate so much working capital over
twenty years that its balance sheet looks wonderfully safe while quietly
producing a terrible return on capital.
So I want to separate three questions:
- What is net working capital?
- How much does this particular business actually need?
- When I buy it, who is responsible for delivering that amount?
The third question is where the NWC peg enters the deal.
And getting that wrong can turn a $2 million acquisition into a $2.3
million acquisition without anyone changing the purchase price.
What Net Working Capital Actually Is
At the broad accounting level:
Net Working Capital = Current Assets — Current Liabilities
BDC defines working capital in essentially those terms: the current
assets available after current liabilities are accounted for. It is a
basic measure of short-term financial capacity and liquidity. BDC’s
working-capital guide is a useful Canadian overview.
Suppose a company’s balance sheet looks like this:
Current Assets Amount
Cash $250,000
Accounts receivable $500,000
Inventory $400,000
Prepaid expenses $50,000
Total current assets $1,200,000
And:
Current Liabilities Amount
Accounts payable $350,000
Accrued expenses $100,000
Current portion of term debt $75,000
Income taxes payable $50,000
Total current liabilities $575,000
Basic accounting NWC is:
$1,200,000 — $575,000 = $625,000
Useful.
But that is usually not the number I want to drop directly into a
purchase agreement.
Acquisition NWC is more specific.
In a typical cash-free, debt-free transaction, cash is excluded because
the seller keeps it, and debt or debt-like items are dealt with
separately because the purchase price is based on enterprise value
rather than the seller’s financing structure.
The transaction might therefore define working capital more like this:
Included Operating NWC Amount
Accounts receivable $500,000
Inventory $400,000
Prepaid operating expenses $50,000
Less: accounts payable ($350,000)
Less: accrued operating expenses ($100,000)
Transaction NWC $500,000
Cash is gone.
Term debt is gone.
Income tax payable may also be excluded depending on the agreed
definition and deal structure.
Now we have a number that is much closer to the capital tied up in the
normal operating cycle.
And this is the first important lesson:
There is no useful NWC discussion in an acquisition until everyone
agrees on what goes into the calculation.
The formula is easy.
The definition is the negotiation.
What NWC Really Means
The accounting definition is technically correct and economically
incomplete.
I think about net working capital as:
The buyer’s capital that is temporarily trapped between paying for
the work and getting paid for sales.
That is not a formal accounting definition.
It is the one that makes the economics intuitive.
Imagine a manufacturer receives an order for $200,000.
It buys $80,000 of raw material.
It pays employees to turn that material into a product.
The product sits in inventory.
It ships.
The customer gets an invoice with 60-day terms.
The supplier wants its money in 30 days.
Payroll wants its money Friday.
The customer wants to pay two months from now.
Somebody has to fund that gap.
That somebody is the business.
Working capital is the money sitting in that gap.
The operating cycle can be simplified into three major components:
Inventory days — how long cash sits in product before sale.
Receivable days — how long cash sits in an invoice after sale.
Payable days — how long suppliers effectively finance the business
before they get paid.
Put them together and we get the cash conversion cycle:
Days Inventory Outstanding + Days Sales Outstanding — Days Payables
Outstanding
The longer the cycle, the longer the owner’s capital is trapped inside
operations.
This is why two companies with identical revenue and EBITDA can have
completely different economics.
Two $5 Million Businesses That Are Not Remotely the Same
Consider two companies.
Both produce:
- Revenue: $5 million
- EBITDA: $750,000
- EBITDA margin: 15%
Company A is a service business.
Customers pay quickly. There is almost no inventory. Suppliers are
limited.
It operates with roughly $150,000 of normalized NWC.
Company B distributes specialized industrial equipment.
It carries substantial inventory and gives major customers 60-day terms.
It needs $1 million of normalized NWC.
Both businesses generate $750,000 of EBITDA.
But Company B requires another $850,000 of permanent capital tied
up in the operating cycle.
If both companies sell for $3.75 million, or five times EBITDA, I do
not think their economics are actually identical.
The enterprise-value multiple may be identical.
The capital intensity is not.
This is one reason I increasingly care about return on invested
capital, not simply EBITDA.
Company A may produce the same earnings while requiring dramatically
less money to keep the machine turning.
That is a better business characteristic.
Positive Working Capital Is Not Free Money
This is where the language gets confusing.
If a company has $500,000 of net working capital, it is tempting to
think:
Great. I am buying $500,000 of extra assets.
Sort of.
But those assets are not sitting there waiting for me to take them home.
The receivables will turn into cash, but that cash is needed to pay
suppliers, employees and replace the inventory that generated those
receivables.
The inventory will sell, but then more inventory has to be bought.
The payables will be paid, but new payables will arise.
In a healthy operating company, NWC is constantly changing form.
Inventory becomes a sale.
A sale becomes a receivable.
A receivable becomes cash.
Cash pays a supplier.
The supplier delivers more inventory.
Round we go.
That is why I think of normalized NWC as a permanent investment in a
temporary collection of assets and liabilities.
The individual invoices and widgets disappear.
The capital requirement remains.
Why the Seller Cannot Just Take the Receivables
This becomes critical in an acquisition.
Imagine the business normally requires:
- $500,000 accounts receivable
- $400,000 inventory
- $350,000 accounts payable
- $50,000 accrued operating liabilities
Normalized NWC:
$500,000 + $400,000 — $350,000 — $50,000 = $500,000
Now suppose the seller says:
I’m selling you the business for $2 million, but the receivables are
mine. I earned them.
Fine.
Then what am I buying?
If the seller removes $500,000 of receivables and I inherit the
inventory, payables and accrued expenses, I start with essentially no
operating liquidity.
Customers may not pay me for another 60 days.
Employees still expect payroll.
Suppliers still expect payment.
I may need to inject hundreds of thousands of dollars immediately.
The seller is perfectly entitled to negotiate a transaction in which he
keeps the receivables.
I am perfectly entitled to reduce what I pay for the business or
explicitly fund the working-capital shortfall.
What makes no sense is valuing the company on earnings generated using
$500,000 of working capital and then pretending that capital is
unrelated to the transaction.
If the EBITDA requires the NWC, the NWC is part of the economic engine I
am buying.
Enterprise Value Is Usually Cash-Free and Debt-Free — Not Working-Capital-Free
This distinction matters.
Suppose we agree the business is worth:
5× $500,000 EBITDA = $2.5 million enterprise value
The conventional concept is often that the business transfers on a
cash-free, debt-free basis with a normalized level of working
capital.
That does not mean every Canadian private transaction is structured
exactly that way. Deal definitions vary and asset purchases can behave
differently from share purchases.
But conceptually it is useful.
I am paying $2.5 million for the operating enterprise.
The seller generally keeps excess cash.
The seller generally clears debt or the purchase price is adjusted for
it.
But the company is expected to arrive with enough ordinary working
capital to continue operating at the level on which the valuation was
based.
BDC makes the practical buyer’s point clearly in its discussion of
purchase agreements: there is usually a working-capital adjustment tied
to the condition of the company at closing, and a reasonable target
should be identified so the buyer can operate on day one without
immediately injecting additional funds. BDC’s purchase-agreement
guide is unusually direct on this issue.
That target is the peg.
The NWC Peg
The net working capital peg is the agreed target amount of working
capital the seller is expected to deliver with the business at closing.
Suppose diligence shows normalized NWC is:
$500,000
The purchase agreement says the NWC peg is $500,000.
At closing, actual NWC is calculated.
Scenario 1: Seller delivers $500,000
Perfect.
No adjustment.
Scenario 2: Seller delivers $400,000
There is a $100,000 shortfall.
The purchase price is generally reduced by $100,000, subject to
whatever mechanism and thresholds the parties negotiated.
Scenario 3: Seller delivers $600,000
There is $100,000 excess NWC.
The seller generally receives another $100,000. And best that the Seller note (VTB loan) is adjusted, not the down payment.
The exact legal mechanics vary, but the economic principle is
straightforward:
Purchase Price Adjustment = Closing NWC — NWC Peg
If closing NWC is below the peg, price moves down.
If it is above the peg, price moves up.
This is not supposed to be a second negotiation over the value of the
business.
It is supposed to ensure I receive the amount of operating capital
assumed when we agreed on the value in the first place.
The Peg Is Not a Bonus for the Buyer
I think this is worth emphasizing because sellers can understandably
look at a working-capital peg and think:
I have to leave $500,000 in the company for free?
No.
Not really.
The $500,000 was already inside the business generating the earnings on
which the purchase price was based.
If we agree the company is worth five times $500,000 of EBITDA, I am
paying for a functioning operating company capable of producing that
$500,000.
If the company requires $500,000 of normalized NWC to do that,
delivering the working capital is part of delivering the business.
The seller still gets the $2.5 million enterprise value.
The seller generally keeps excess cash.
The seller gets credit if actual working capital exceeds the agreed
target.
What the seller cannot logically do is receive the full value of the
functioning company and also strip out the operating capital required to
make it function.
Or, more accurately, he can try.
That is why I want the peg in writing.
Why I Want the NWC Mechanism in the LOI
BDC notes that an LOI provides the negotiation framework and anchors the
transaction terms before full diligence. Its due-diligence guidance
specifically lists working-capital levels among the financial areas a
buyer should examine. BDC’s due-diligence
guide
is a good overview of the process.
I would go one step further.
For a business with meaningful working capital, I do not want the LOI to
say only:
Purchase price: $2,500,000.
I want the economics described more like:
$2,500,000 enterprise value, on a cash-free, debt-free basis,
assuming delivery at closing of a normalized level of net working
capital, with the NWC peg and calculation methodology to be
established through financial due diligence and reflected in the
definitive purchase agreement.
I am not suggesting anyone copy that sentence into a legal document. A
transaction lawyer should draft the actual language.
The point is to establish the principle before exclusivity and
diligence.
Why?
Because otherwise buyer and seller may have completely different ideas
about what $2.5 million buys.
I may believe I am buying the operating business with normal working
capital.
The seller may believe he is selling the shares for $2.5 million,
paying himself the cash, collecting the receivables and running
inventory down before closing.
Those are not minor drafting differences.
Those can be hundreds of thousands of dollars of economic disagreement.
I would rather discover that disagreement before I spend $30,000 on
lawyers, accountants and a quality-of-earnings report.
The LOI Does Not Need the Final Peg — But It Needs the Rule
At LOI stage, I may not know whether normalized NWC is $450,000 or
$525,000.
That is what diligence is for.
I may not yet know which accruals belong in the definition.
I may discover seasonality.
I may discover the seller changed inventory practices last year.
I may discover one giant overdue receivable that should never have been
treated as normal.
Fine.
The final peg can wait.
The economic framework should not.
I want the LOI to make clear that:
- the agreed price is based on a cash-free/debt-free enterprise value
if that is the intended structure, - a normalized amount of NWC will be delivered,
- the amount and definition will be established during diligence,
- the definitive agreement will include a closing adjustment.
That keeps the detailed accounting discussion where it belongs without
leaving the basic economics open.
And Then It Has to Survive Into the Purchase Agreement
The LOI sets the expectation.
The definitive purchase agreement does the actual work.
Osler notes that purchase-price adjustments based on working capital
and/or debt at closing are often included in Canadian private-business
acquisition agreements. Osler’s guide to acquisitions of private
businesses in Canada describes the mechanism as a normal part
of transaction documentation.
Blakes goes further in its Canadian M&A guide: completion-accounts
adjustments, including working-capital adjustments, are commonly used in
Canadian private transactions. Blakes’ Doing Business in Canada
guide is useful context for how these deals are normally structured.
The purchase agreement needs more than a sentence saying “working
capital adjustment.”
It needs to define the battlefield.
At minimum, I would expect the advisors to address:
- exactly which current assets are included,
- exactly which current liabilities are included,
- whether cash is excluded,
- what qualifies as debt or debt-like,
- treatment of income taxes,
- treatment of sales taxes,
- bad-debt reserves,
- obsolete inventory reserves,
- accrued bonuses,
- vacation pay,
- customer deposits,
- deferred revenue,
- prepaid expenses,
- related-party balances,
- accounting policies,
- consistency with historical accounting,
- the peg itself,
- who prepares the closing statement,
- how long the other party has to object,
- how disputes are resolved,
- when the adjustment is paid.
If that sounds excessively detailed, imagine arguing over whether
$175,000 of slow-moving inventory counts after the company is already
yours.
I prefer detail.
How Do You Actually Set the Peg?
The lazy answer is:
Take the last twelve months’ average NWC.
Sometimes that works.
Sometimes it is badly wrong.
Suppose monthly NWC over the last year was:
Month NWC
January $420,000
February $430,000
March $450,000
April $470,000
May $500,000
June $540,000
July $580,000
August $600,000
September $570,000
October $520,000
November $470,000
December $390,000
Average: roughly $495,000.
If I close December 31 and insist on $495,000 because that is the
annual average, the seller may reasonably say I am demanding far more
working capital than the company normally carries at that point in the
season.
If I close August 31 and accept $495,000, I may be underfunded
immediately.
Seasonality matters.
The peg should represent the normalized amount required at the closing
date to operate the business in the ordinary course, not whatever
average produces the answer one side prefers.
Historical Averages Are the Beginning, Not the End
I would want at least 24 months of monthly balance-sheet data for a
meaningful working-capital business.
Three years is better if the data is clean.
Then I would look for:
- seasonality,
- growth,
- unusual inventory builds,
- collection problems,
- changes in supplier terms,
- changes in customer terms,
- COVID-era distortions if older periods are still in the sample,
- acquisitions or lost customers,
- changes in accounting policy,
- one-time large projects.
Suppose the company has grown 30% over the last two years.
Using a three-year average NWC may understate what today’s revenue base
actually requires.
Suppose the company lost a huge inventory-heavy product line six months
ago.
The historical average may overstate current needs.
The peg is not an archaeological average.
It is an estimate of normal operating capital at closing.
NWC as a Percentage of Revenue
One useful cross-check is to express NWC relative to sales.
Suppose:
- Revenue: $6 million
- Normalized NWC: $900,000
NWC is:
15% of revenue
If the company grows to $8 million and its operating model does not
change, I might expect something around:
$8 million × 15% = $1.2 million
That means $2 million of revenue growth could consume roughly
$300,000 of additional capital.
This is exactly why EBITDA growth and cash generation are not the same
thing.
The company can grow beautifully and still make me reach for the line of
credit.
Growth Eats Working Capital
This is one of the least intuitive parts of a growing business.
Suppose a distributor generates:
- $5 million revenue
- $750,000 EBITDA
- $750,000 NWC
Next year revenue grows 20% to $6 million.
Excellent.
Assume EBITDA grows proportionately to $900,000.
On the income statement, I created another $150,000 of EBITDA.
But if NWC remains 15% of sales, working capital rises from:
$750,000 to $900,000
The entire $150,000 of incremental EBITDA has effectively been absorbed
by incremental working capital before taxes, debt service and capex.
That does not mean the growth was worthless.
The company now has a larger earnings base.
But it explains why an owner can stare at a record income statement and
wonder where the cash went.
BDC’s free-cash-flow guidance explicitly includes changes in non-cash
working capital in the calculation because those changes can consume
cash even when accounting earnings are positive. BDC’s free-cash-flow
guide makes the connection clearly.
Profitability pays eventually.
Working capital determines how much money I need while waiting.
Reducing NWC Can Be an Extraordinary Source of Cash
Now we get to the interesting part.
If a company requires $1 million of NWC today and I can operate it
safely with $700,000, I have released:
$300,000 of cash
without:
- adding a customer,
- increasing prices,
- firing an employee,
- borrowing another dollar,
- selling the business.
That is powerful.
This is one reason working-capital improvement is often one of the first
places a sophisticated operator looks after an acquisition.
The cash is already in the business.
It is simply trapped.
The Benefits of Reducing NWC
There are several.
1. More cash
The obvious one.
Collect receivables faster, carry less unnecessary inventory, negotiate
better supplier terms, and cash comes out of the operating cycle.
That cash can:
- repay acquisition debt,
- fund capex,
- finance growth,
- build reserves,
- make distributions,
- finance another acquisition.
2. Higher return on invested capital
Suppose two businesses each produce $500,000 of after-tax operating
profit.
One requires $500,000 of operating capital.
The other requires $2 million.
All else equal, the first company is using capital much more
efficiently.
Reducing NWC means I can generate the same earnings with less money tied
up.
That increases the productivity of the capital I own.
3. Less dependence on the bank
A business with a long cash conversion cycle often needs an operating
line.
That is not inherently bad. Revolving credit exists for a reason.
But a shorter working-capital cycle means less borrowing, less interest
expense and more resilience if a lender tightens terms.
4. Growth becomes easier to finance
If every $1 million of incremental sales requires another $200,000 of
NWC, rapid growth can become a financing problem.
Reduce that requirement to $100,000 and the same growth becomes much
easier to self-fund.
5. Problems become visible faster
Excess inventory can hide forecasting problems.
Old receivables can hide weak customers or weak collection discipline.
Large cash balances can hide sloppy purchasing.
Working-capital optimization forces management to understand the
operating machine.
That alone has value.
But Reducing NWC Is Not the Same as Starving the Business
This is where financial engineering can become operational stupidity.
I can reduce inventory dramatically.
Fantastic.
Then a key customer orders a critical part and I cannot deliver for six
weeks.
I saved working capital and damaged the business.
I can demand every customer pay in 15 days.
Fantastic.
Then the best customers move to competitors offering 45.
I can stretch suppliers from 30 days to 90 without agreement.
Fantastic.
Then they put me on credit hold.
A lower NWC number is not automatically better.
The goal is efficient working capital, not minimum working capital.
I want to remove capital that is not earning its keep.
I do not want to remove the lubrication from the machine.
The Four Levers
There are four obvious places I would look.
Accounts Receivable
If customers take 62 days to pay when the contract says 30, there is
cash available.
Improve:
- invoicing speed,
- invoice accuracy,
- collection discipline,
- credit approval,
- deposits,
- progress billing,
- electronic payment,
- customer terms.
A company can accidentally finance its customers for years because
nobody wants to make an uncomfortable phone call.
Inventory
This can be the biggest opportunity in an industrial business.
Separate:
- genuinely required safety stock,
- fast-moving inventory,
- strategic long-lead items,
- slow-moving inventory,
- obsolete inventory,
- stuff the owner bought because “we might need it.”
Inventory that has not moved in four years is not working capital.
It is a storage hobby.
Accounts Payable
Supplier terms are financing.
If a supplier offers 45 days and I pay in 10, I am voluntarily financing
the supplier.
That may be rational if there is a worthwhile early-payment discount or
the relationship matters.
Otherwise, I would rather keep the cash for the period I am
contractually allowed to keep it.
The Operating Process Itself
The biggest improvements may not come from finance at all.
Shorter production cycles.
Better forecasting.
Smaller batch sizes.
Vendor-managed inventory.
Drop shipping.
Faster quality release.
Better scheduling.
Standardized components.
The best working-capital improvement is often an operational improvement
that happens to release cash.
Why Debt-Free Businesses Often Have Too Much NWC
This is one of the patterns I find especially interesting in older
private companies.
A founder builds a business for thirty years.
The mortgage on the building is gone.
The equipment is paid for.
There is no acquisition debt.
The company is profitable.
The owner is conservative.
Cash accumulates.
Inventory accumulates.
Receivables are collected eventually.
Nobody is measuring return on invested capital because there is no
outside investor asking the question.
The business becomes financially bulletproof.
It can also become incredibly capital-inefficient.
This is not irrational from the seller’s perspective.
If I am 67 years old, debt-free and making $500,000 a year, perhaps I
care much more about never missing payroll than squeezing an extra three
percentage points out of return on capital.
A $500,000 cushion sitting in inventory and receivables may help me
sleep.
There is value in that.
But a new buyer has a different balance sheet.
I may have just:
- put $500,000 of equity into the acquisition,
- borrowed $1 million from a bank,
- issued a $500,000 vendor note,
- personally guaranteed part of the financing.
Capital that was harmlessly inefficient under the seller can become
extremely expensive under me.
Debt Creates Discipline
Debt gets criticized, often correctly, for increasing risk.
But it also imposes a discipline that a debt-free company may never have
needed.
When I have monthly principal and interest payments, I suddenly care
very much whether customers pay in 62 days or 42.
I care whether $300,000 of inventory has not moved in eighteen months.
I care whether we pay suppliers two weeks before invoices are due.
The seller may have financed all of this internally for decades.
I am financing it partly with borrowed money.
The opportunity cost is no longer theoretical.
This is why a debt-free acquisition can contain a hidden source of
value: the seller may have optimized the company for safety rather
than capital efficiency.
The buyer may be able to keep most of the safety while releasing a
meaningful amount of cash.
Excess Cash Is Not the Same as Excess NWC
Important distinction.
A debt-free company may have:
- $1 million cash,
- $800,000 receivables,
- $900,000 inventory,
- $500,000 payables.
It looks like a mountain of working capital.
But if the deal is cash-free/debt-free, the $1 million cash normally
goes to the seller.
Transaction NWC might be:
$800,000 + $900,000 — $500,000 = $1.2 million
The question is whether the company actually needs $1.2 million.
Maybe it does.
Maybe normalized NWC is $900,000 and the seller has $300,000 of excess
inventory and receivables.
The $1 million cash is a separate issue.
I would not conflate them.
Excess cash is generally a balance-sheet asset outside enterprise value.
Excess NWC is operating capital above the normalized level required by
the enterprise.
Different problem.
Why Sellers Can Accidentally Inflate the Peg
There is a flip side to the debt-free-company problem.
Suppose a business has historically been sloppy with working capital.
Receivables average 70 days.
Inventory is bloated.
Suppliers are paid early.
Historical average NWC is $1.4 million.
Seller says:
There you go. The peg is $1.4 million.
As the buyer, that sounds wonderful because the seller has to deliver a
lot of working capital.
But if the seller delivers $1.4 million and I can release $400,000
after closing through better management, I have effectively found cash
inside the deal.
That can be real value.
However, the seller and his advisors may recognize this too.
They may argue that $1.4 million is not normalized NWC because
$400,000 is excess.
Now we have a real negotiation.
This is why the peg is not automatically the historical average.
The seller does not necessarily owe me every inefficiency he accumulated
over thirty years.
I am buying a business with a normalized operating requirement.
If there is clearly excess working capital, the seller has a legitimate
argument that it should be extracted or paid for separately.
The interesting question becomes:
Where does normal end and excess begin?
That is what diligence has to answer.
Why Buyers Can Abuse the Peg Too
Buyers are not innocent here.
A buyer can push for an artificially high peg to create a purchase-price
reduction at closing.
Suppose normal NWC is clearly around $800,000.
Buyer insists on a $1 million peg.
Closing NWC is $820,000.
Buyer claims a $180,000 price reduction.
That is not a working-capital adjustment.
That is a disguised renegotiation of purchase price.
A fair peg should protect the economics both parties agreed to.
It should not be a weapon.
If I need the transaction to be $200,000 cheaper, I would rather
negotiate the price honestly.
The Peg Can Move the Effective Purchase Price Dramatically
Let’s build a realistic acquisition.
Headline deal
- Normalized EBITDA: $500,000
- Multiple: 4×
- Enterprise value: $2,000,000
- Buyer equity: $500,000
- Senior debt: $1,000,000
- Vendor take-back: $500,000
Looks tidy.
Now suppose normalized NWC should be $600,000.
Version A — Proper peg
The LOI and purchase agreement require $600,000 of NWC.
Seller delivers $600,000.
Buyer funds:
$500,000 equity
The business arrives properly capitalized.
Version B — No peg, seller strips working capital
Seller collects receivables aggressively, stops replenishing inventory
and pays himself the cash.
Closing NWC: $300,000.
Buyer still pays $2 million.
Then the buyer discovers the company needs another $300,000 to function
normally.
Effective buyer capital requirement:
$500,000 acquisition equity + $300,000 NWC injection = $800,000
The headline purchase price did not change.
My required equity increased 60%.
That is why this matters.
The Seller Can Manipulate Closing NWC Without Technically Stealing Anything
This is another reason the agreement needs accounting rules.
In the months before closing, a seller who knows working capital matters
can change behaviour.
He can:
- delay paying suppliers,
- accelerate collections,
- stop buying inventory,
- delay bonuses,
- defer repairs,
- invoice customers unusually early,
- push shipments across the closing date.
Some of these actions increase closing cash.
Some change NWC.
Some do both.
None necessarily constitutes fraud.
But they can leave the buyer with a business that looks normal in the
closing calculation and is operationally depleted.
The purchase agreement therefore needs ordinary-course covenants and
consistent accounting policies, not just a single number.
Blakes notes that Canadian private-company purchase agreements commonly
include pre-closing covenants designed to keep the target operating in
the ordinary course between signing and closing. That matters enormously
when working capital is part of the price adjustment.
I do not just want $600,000 of NWC.
I want $600,000 of good NWC generated in the ordinary course.
A Receivable Is Only Worth What Gets Collected
Suppose the closing balance sheet shows:
Accounts receivable: $700,000
Excellent.
How old?
- Current: $350,000
- 31–60 days: $150,000
- 61–90 days: $75,000
- 91–120 days: $50,000
- 120+ days: $75,000
Suddenly I am less excited.
If $100,000 of those receivables are unlikely to be collected, counting
them at face value overstates NWC.
The peg and closing calculation need appropriate reserves.
The same applies to:
- disputed invoices,
- credits owed to customers,
- warranty claims,
- related-party receivables,
- amounts owed by the seller.
I want working capital that turns into cash.
Not working capital that looks nice in Excel.
Inventory Is Even More Dangerous
Inventory is where I would expect some of the ugliest arguments in an
industrial acquisition.
The balance sheet says:
Inventory: $1.2 million
Wonderful.
Then I walk the warehouse.
There are parts for products discontinued in 2017.
Custom components for a customer who disappeared.
Boxes nobody has opened in six years.
Slow-moving spare parts carried at full cost.
Work in process with questionable recoverability.
Inventory can be an asset, a moat, an insurance policy or a museum.
Sometimes all four are in the same building.
The working-capital definition needs an inventory reserve policy.
And diligence needs to test it.
Otherwise the seller can satisfy a $900,000 NWC peg by leaving me
$400,000 of useful receivables and $500,000 of archaeology.
Customer Deposits and Deferred Revenue Can Reverse the Intuition
Some businesses operate with negative working capital.
Customers pay before the company delivers.
Think:
- subscriptions,
- memberships,
- deposits,
- retainers,
- certain e-commerce models,
- prepaid service contracts.
Suppose customers have paid $500,000 in advance.
Cash may go to the seller in a cash-free transaction.
But the company still owes $500,000 of future product or service.
That deferred-revenue liability matters.
A business can have negative NWC and still be excellent because
customers are financing operations.
In fact, that can be one of the best business models in the world.
But in an acquisition, I need to understand exactly which liabilities
transfer and which cash stays.
If the seller keeps the prepaid cash and I inherit the obligation to
perform the work, I have a problem.
Again:
The formula is easy.
The definition is the negotiation.
Asset Purchase vs Share Purchase Changes the Mechanics
NWC deserves attention in either structure, but the mechanics can
differ.
In a share purchase, I acquire the corporation itself.
Its receivables, inventory, payables and other working-capital accounts
remain inside the company unless adjusted before closing.
The working-capital peg naturally becomes part of the equity-value
bridge.
In an asset purchase, the agreement specifies which assets and
liabilities I actually acquire.
Maybe I buy:
- inventory,
- receivables,
- prepaid expenses,
and assume:
- ordinary trade payables,
- certain accruals.
Or maybe I do not assume payables at all.
The economics still have to work.
If I buy the operating assets but not the liabilities that historically
financed them, my working-capital requirement can actually increase.
This is why “asset deal” does not eliminate the NWC problem.
It changes the components.
A Canadian transaction lawyer and accountant need to build the mechanism
around the actual structure rather than importing a generic peg from
another deal.
NWC Is Also a Financing Question
Suppose my acquisition financing is:
- $500,000 buyer equity
- $1 million senior term loan
- $500,000 VTB
Total: $2 million.
Perfect.
Except the business needs another $400,000 seasonal working-capital
facility.
Did I arrange that?
BDC’s acquisition-financing guidance emphasizes that the financing
package needs to leave enough flexibility for the business to operate
and grow after the transaction. BDC’s acquisition-financing
guide is a useful starting point.
I would think of the capital structure in two buckets:
Acquisition capital buys the business.
Operating capital lets me run it.
A term loan designed to amortize over several years is not necessarily
the right tool for seasonal inventory swings.
An operating line secured against receivables and inventory may be.
The acquisition is not fully financed until both buckets are solved.
The Bank Will Care About This Too
A lender financing the acquisition has the same basic concern I do.
Can the company actually operate after closing?
If the buyer uses every available dollar for purchase price and then
discovers payroll, inventory and receivables require another $300,000,
the lender has inherited a fragile borrower.
That is why working-capital diligence should connect directly to
financing discussions.
I would want to know:
- normalized permanent NWC,
- seasonal peak NWC,
- minimum liquidity,
- borrowing-base availability,
- unused line capacity,
- growth-related NWC requirements.
A company can have enough working capital on the average day and still
run out of cash in September.
What I Would Look for in a Debt-Free Seller
A debt-free business is especially interesting because the balance sheet
may contain years of accumulated habits.
I would look for:
Receivables: Are customers paying slowly because the industry
requires it, or because nobody collects?
Inventory: Is the stock required for service levels, or has the
owner simply never thrown anything away?
Payables: Is the company paying suppliers early because discounts
justify it, or because cash is abundant?
Deposits: Could customers fund more of the cycle?
Purchasing: Are order quantities based on economics or habit?
Seasonality: Is the owner carrying peak inventory year-round?
Cash: How much is truly required as operating cash versus
accumulated surplus?
The debt-free seller may have built an exceptionally safe business.
I do not want to destroy that.
But I also do not want to finance his thirty-year comfort buffer at
acquisition-debt interest rates.
A $400,000 NWC Improvement Can Change the Acquisition Return
Suppose I buy a business for $2.5 million.
I invest $600,000 of equity.
The company arrives with $1.2 million of normalized NWC because that is
how the seller historically operated.
Over two years I improve:
- receivable days,
- inventory turns,
- supplier terms,
without hurting customers or operations.
The company can now operate safely with $800,000.
I release:
$400,000
Suppose I use all $400,000 to repay acquisition debt.
I have effectively recovered two-thirds of my original $600,000 equity
contribution through operating improvement, while still owning the
business.
That is extraordinary.
And unlike EBITDA growth, I did not need the market to give me another
customer.
This is why working-capital optimization can be such a powerful
acquisition thesis.
But I would be cautious about underwriting the deal on that improvement
before I own it.
The seller may have more working capital for a reason I have not yet
understood.
Treat the release as upside.
Do not need it for the deal to survive.
NWC Reduction Can Create Value Twice
There is another interesting effect.
Suppose I release $400,000 from NWC and pay down debt.
First benefit:
$400,000 less debt.
Second benefit:
lower interest expense and better debt-service coverage.
Potential third benefit:
the company may become more attractive to a future buyer because it has
better cash conversion and cleaner operating discipline.
But I would not automatically add the $400,000 to EBITDA or slap a
multiple on it.
Working-capital release is principally a balance-sheet and cash-flow
improvement.
The value comes from needing less capital to support the same earnings.
That is enough.
The Best NWC Is Business-Model Dependent
There is no universal “good” NWC percentage.
A consulting firm may need almost none.
A distributor may need a lot.
A manufacturer may need even more.
A grocery retailer can operate with negative working capital because
customers pay immediately while suppliers are paid later.
A custom-equipment manufacturer may have enormous work in process and
milestone billing.
A seasonal company may swing from $300,000 to $1.5 million during the
year.
This is why BDC’s generic current-ratio guidance is useful for financial
health but cannot set an acquisition peg for me.
The peg has to come from the operating reality of the specific company.
The NWC Peg I Would Want to See in an LOI
Again, this is commercial thinking, not legal drafting.
For a meaningful working-capital business, I would want the LOI to
establish something along these lines conceptually:
The purchase price reflects an enterprise value of $X on a cash-free,
debt-free basis and assumes the delivery of a normalized level of net
working capital sufficient to operate the business in the ordinary
course. The parties will establish the NWC peg and detailed definition
during financial due diligence based on historical monthly working
capital, seasonality, current operating requirements and consistent
accounting policies. The definitive purchase agreement will provide a
dollar-for-dollar purchase-price adjustment for closing NWC above or
below the agreed peg.
That one paragraph prevents a remarkable amount of future confusion.
I would also want the LOI to identify any obvious special issue already
known:
- inventory excluded from the transaction,
- receivables retained by seller,
- customer deposits,
- unusual seasonal closing date,
- large related-party balance.
If it can move the economics by six figures, it belongs in the early
conversation.
Then the Purchase Agreement Needs a Schedule
This is where lawyers and accountants become essential.
I would want the definitive agreement to contain an illustrative NWC
schedule using actual historical accounts.
Something like:
Included Excluded
Trade accounts receivable Cash
Eligible inventory Income tax receivable
Ordinary prepaid expenses Related-party receivables
Trade accounts payable Bank debt
Accrued payroll Shareholder loans
Accrued vacation Transaction expenses
Other agreed operating accruals Income tax payable
The exact list depends on the company.
But the schedule forces everyone to confront the same question before
closing.
It also establishes accounting consistency.
If inventory historically carried a 5% obsolescence reserve, the seller
should not suddenly eliminate the reserve on the closing balance sheet.
If doubtful accounts were historically reserved after 90 days, closing
should not invent a 180-day policy.
The accounting rules are part of the economics.
The Closing Adjustment Is Often Estimated First
Practically, final numbers may not exist at the instant the deal closes.
Invoices are still arriving.
Bank reconciliations need completion.
Inventory needs counting.
So transactions often use an estimated closing working-capital figure,
make an initial adjustment, then true it up after closing once the final
closing accounts are prepared.
The purchase agreement determines:
- who prepares the statement,
- how many days they have,
- the review period,
- objection procedures,
- dispute resolution,
- final payment timing.
This is not glamorous.
It is exactly the sort of thing that prevents two angry owners from
arguing over $87,436 three months after closing.
What I Would Ask During NWC Due Diligence
If I were buying a business with meaningful receivables or inventory, I
would want:
- 24–36 months of monthly balance sheets.
- Monthly NWC calculated using the proposed transaction
definition. - Accounts-receivable aging by customer.
- Bad-debt history and write-offs.
- Customer payment terms and actual days-to-pay.
- Inventory by SKU, age and last movement date.
- Inventory obsolescence policy and historical write-downs.
- Accounts-payable aging by supplier.
- Supplier terms and early-payment discounts.
- Accrued payroll, vacation, bonuses and commissions.
- Customer deposits and deferred revenue.
- Sales-tax balances and other statutory liabilities.
- Related-party balances.
- Seasonal peak and trough working-capital requirements.
- Any changes in accounting policy during the historical period.
- Revenue growth assumptions and the NWC required to support them.
- Operating-line history and borrowing-base calculations.
- A physical inventory review where inventory is material.
Then I would ask the most important question:
What does this business need on the morning after I own it?
Not what number makes the historical average work.
Not what number maximizes the seller’s proceeds.
Not what number minimizes my purchase price.
What does the business need?
NWC Should Change How I Compare Acquisition Targets
This is where the concept gets bigger than transaction mechanics.
Imagine two businesses each available for $2 million.
Business A
- EBITDA: $500,000
- Normalized NWC: $200,000
- Maintenance capex: $50,000
Business B
- EBITDA: $500,000
- Normalized NWC: $900,000
- Maintenance capex: $150,000
Both are “4× EBITDA.”
They are not equally attractive businesses.
Business B requires:
- $700,000 more permanent working capital,
- $100,000 more annual maintenance capex.
If growth requires working capital proportionate to sales, Business B
may also consume far more cash as it expands.
This does not make Business B bad.
Maybe it has a much stronger moat.
Maybe the inventory creates customer loyalty.
Maybe the equipment creates barriers to entry.
Maybe its earnings are far more durable.
But the EBITDA multiple alone hides a huge part of the capital
requirement.
This is the same lesson I keep running into as I look at acquisitions:
The earnings number is only useful when I understand what the business
had to consume to produce it.
SDE, EBITDA and NWC Belong in the Same Conversation
This is why I would put this article immediately beside the SDE/EBITDA
discussion in the Business & Independent Income for
Canadians
roadmap.
SDE asks:
How much economic benefit is available to one working owner?
Normalized EBITDA asks:
What does the business earn after paying fair market costs to operate
it?
NWC asks:
How much capital has to remain trapped inside the operating cycle to
produce those earnings?
Free cash flow then asks:
After all of that, how much cash actually comes out?
These are not competing metrics.
They are layers.
And the further I get into acquisition analysis, the less interested I
am in any one headline number.
The Seller Built the Balance Sheet. I Have to Buy the Future.
There is a subtle philosophical difference between the seller and buyer
here.
The seller’s balance sheet is the result of decades of decisions.
Maybe he likes six months of inventory.
Maybe he never uses the line of credit.
Maybe every customer gets 60 days because he values relationships.
Maybe he pays every supplier the day the invoice arrives.
Maybe the company has $2 million sitting in cash because he remembers
2008.
That balance sheet may have served him extremely well.
I am not buying his history.
I am buying the company’s future under a completely different capital
structure.
If I am using acquisition debt, my cost of capital is higher.
If I want to grow, my working-capital needs may increase.
If I want to professionalize operations, I may be able to reduce the
amount of capital trapped in the cycle.
That makes NWC part of the acquisition thesis, not merely a closing
calculation.
Where This Leaves Me
If I were buying a $2 million operating business tomorrow, I would not
think of the purchase price as $2 million until I understood the
working capital.
I would want to know:
- What is included in NWC?
- What is the historical monthly range?
- What is normal?
- What is seasonal?
- What is excess?
- What is obsolete?
- How much does growth consume?
- How much can safely be released?
- What operating line is required?
- What amount is the seller delivering at closing?
- What happens to the price if he does not?
Only then do I know what the acquisition actually costs.
A business with $500,000 of EBITDA and a $2 million enterprise value
may be a $2 million acquisition.
Or it may be a $2 million acquisition plus a $300,000 surprise cheque.
The difference is often one paragraph in the LOI.
That paragraph matters.
Because I am not buying a pile of assets frozen on a closing balance
sheet.
I am buying a moving machine.
Receivables have to turn into cash.
Inventory has to turn into sales.
Suppliers have to get paid.
Employees have to make payroll.
And on the morning after closing, the machine cannot stop while I
explain that the purchase price used up all my money.
The purchase price buys the business.
Net working capital keeps it alive.
I want both negotiated before I sign the cheque.
Disclaimer: This article is for general informational purposes and
documents how I think about business acquisitions. It is not legal,
accounting, tax, lending, valuation or investment advice. Net working
capital definitions, purchase-price adjustments and transaction
structures are highly deal-specific. A Canadian business acquisition
should be reviewed by qualified legal, accounting, tax and financing
professionals, and the definitive transaction documents should be
drafted for the specific facts of the deal.