Working capital adjustment: Overview, definition, and example
What is a working capital adjustment?
A working capital adjustment is a change in the purchase price of a business based on differences between the expected and actual working capital at the time of closing. Working capital includes a company’s short-term assets and liabilities, such as cash, accounts receivable, and inventory, which are essential for day-to-day operations.
When a business is bought or sold, the buyer and seller often agree on a target working capital level. If the actual working capital at closing is higher or lower than the target, the purchase price is adjusted accordingly to ensure fairness.
Why is a working capital adjustment important?
A working capital adjustment is important because it ensures that a business buyer receives the expected level of working capital needed to run operations immediately after closing. Without this adjustment, a seller could reduce working capital before the sale, leaving the buyer with insufficient resources to pay short-term obligations.
For sellers, the adjustment helps reflect a fair value for the business at the time of sale, preventing last-minute changes that could reduce the expected proceeds. It also encourages both parties to maintain stable financial operations leading up to the transaction.
Understanding working capital adjustment through an example
Imagine a buyer agrees to purchase a retail business based on an expected working capital of $500,000. At closing, the actual working capital is only $450,000 because the seller used cash to pay off outstanding debts. Since the working capital is lower than expected, the purchase price is reduced by $50,000 to reflect the shortfall.
Conversely, if the working capital at closing is $550,000—$50,000 higher than the agreed target—the buyer pays an additional $50,000 to compensate the seller for the extra working capital left in the business.
An example of a working capital adjustment clause
Here’s how a clause related to a working capital adjustment might appear in a contract:
“The purchase price shall be adjusted based on the difference between the Target Working Capital and the Actual Working Capital as of the Closing Date. If the Actual Working Capital exceeds the Target Working Capital, the Purchase Price shall be increased accordingly. If the Actual Working Capital is less than the Target Working Capital, the Purchase Price shall be reduced by the shortfall.”
Conclusion
A working capital adjustment ensures that both buyers and sellers receive a fair deal when a business is sold. It prevents unexpected financial shortfalls for the buyer while ensuring the seller is compensated for any excess working capital left in the company.
By including a clear working capital adjustment clause in a purchase agreement, businesses can reduce disputes, maintain financial transparency, and ensure a smooth transaction.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.