One might think that calculating net working capital is a relatively simple exercise — current assets less current liabilities. However, this simple exercise can turn into a very complicated calculation during a transaction process. At a time when both buyers and sellers just want to move on, they instead face potential arbitration or litigation post-close that could have been avoided overall.

To avoid additional costs and strained relationships, buyers and sellers should take care to avoid common mistakes that can be divided into 3 categories: When Setting the Target, When Drafting Legal Documents, and After the Close.

Today’s focus is on When Drafting Legal Documents

  1. Including an NWC target in the Letter of Intent (LOI)

As the LOI is typically signed prior to diligence being performed, the initial target set might be missing crucial items and/or might include items that should not be included in the calculation, such as shareholder receivables, payables, or income taxes.

  1. Using contradicting language in the purchase and sales agreement

This is more common than you think, so make sure intention matches execution. Common language used in sales agreements states that the NWC reconciliation should be calculated using generally accepted accounting principles (GAAP) consistent with past practices. However, these concepts are rarely in sync. If seller financials are “mostly” GAAP but exclude certain accruals, it is important to ensure the exclusions would not have a material effect.

Frequently missed accruals include vacation, warranty reserves, AROs, and accrued property taxes. There are also potential GAAP adjustments on the asset side of the balance sheet, such as inadequate accounts receivable and inventory reserves. A buyer can determine that the net realizable value of these assets is lower than the reported amount resulting in an NWC shortfall.

  1. Not using an illustrative example in the purchase and sales agreement

There’s always going to be room for interpretation when you describe something, so include an example to alleviate confusion. In any balance, estimations are used, but how those estimations have been historically calculated should be clearly defined and shown in the sales agreement. Examples show which assets and liabilities are included in the target NWC and which ones should ultimately be included or excluded in the reconciliation.

  1. Not communicating post-close exclusions

It is important to have clear agreement regarding who is responsible for what upon a change in ownership. If payroll-related expenses are to be the responsibility of the seller upon close, they should be excluded from the calculation. Income tax and owner-related items are also normally excluded, as are cash and debt. If there are checks in excess, decide and agree if those are to be included or excluded and are properly noted as such in the final agreement.

Check back for Part 3 of this series – Avoid These Mistakes When Calculating Working Capital – After the Close

Part 1 – Avoid These Mistakes When Calculating Working Capital – When Setting the Target


If you have any questions, feel free to contact Joan Young, President of Sunbelt Business Brokers, Greater Bay Area – [email protected]. Sunbelt also handles Mergers and Acquisitions.