The Biggest Post-Closing Deal-Killer

What Working Capital Really Means (And Why It Matters)

Net working capital represents the cash your business needs to function during the normal gap between when you pay for things and when customers pay you.

The technical definition? Current assets (cash, accounts receivable, inventory) minus current liabilities (accounts payable, accrued expenses, short-term debt).

It's the money that keeps the business running smoothly. Without adequate working capital, even a highly profitable business can't operate. You might be making great margins on paper, but if you can't cover this week's expenses while waiting for customers to pay their invoices, you're in trouble.

Think of working capital as the fuel in your tank. The business might have a powerful engine (strong profitability), but without enough fuel, you're not going anywhere.

The Rules of Thumb That Actually Work

Working capital needs vary significantly based on your business model, but here are reliable benchmarks I've seen hold true across hundreds of transactions:

Small to Mid-Sized Businesses (Under $10M Revenue)

Service Businesses: 10-15% of annual revenue

These businesses typically have minimal inventory but need to cover payroll and overhead while waiting for client payments.

Example: A $3 million digital marketing agency should maintain $300,000 to $450,000 in working capital. This covers approximately 5-7 weeks of operating expenses, which aligns with typical customer payment cycles.

Product Businesses: 15-25% of annual revenue

Product-based companies need more working capital to fund inventory purchases and longer cash conversion cycles.

Example: A $5 million light manufacturing company requires $750,000 to $1.25 million in working capital. This allows them to purchase raw materials, carry work-in-progress inventory, maintain finished goods, and extend payment terms to customers while their own payables come due.

Lower Middle Market ($10M-$50M Revenue)

Asset-Light Businesses: 8-12% of revenue

Larger service businesses often benefit from economies of scale and more negotiating power with customers on payment terms.

Example: A $20 million SaaS company needs $1.6 million to $2.4 million in working capital. Even with recurring revenue, they need to smooth out the timing between upfront customer acquisition costs, development expenses, and when annual subscriptions actually get collected.

Inventory-Heavy Businesses: 20-30% of revenue

Distribution and retail operations require substantial working capital to maintain adequate stock levels across multiple SKUs.

Example: A $30 million industrial distributor requires $6 million to $9 million in working capital. They need to stock thousands of products and offer net-30 or net-60 terms to contractors, while their suppliers demand payment in 30 days or less.

Why Deals Collapse Over Working Capital

I've watched this scenario play out more times than I can count:

The buyer assumes the cash showing on the trailing balance sheet will transfer with the business. The seller plans to extract every available dollar before closing, leaving just enough to meet the literal definition of "normal operations."

But nobody actually calculates what's required to run the business day-to-day.

Here's what happens next. You close on a Friday. By the following Thursday, you're facing a crisis. Suppliers are calling about overdue invoices. Payroll is hitting in three days. Your new customers haven't paid yet because you just invoiced them on net-30 terms.

You're suddenly forced to inject working capital you never budgeted for. Or worse, the business starts missing payments within weeks of your ownership, damaging supplier relationships and customer confidence you spent good money to acquire.

The seller? They have your purchase price wired to their account and zero obligation to solve your cash flow problem.

How to Protect Yourself: Four Critical Steps

1. Address It in Your Letter of Intent

Don't wait until the purchase agreement. Your LOI should include a working capital target or peg that specifies the business will be delivered with normal operating levels of working capital at closing.

Be specific. "Adequate working capital" is okay. "$875,000 in net working capital, subject to adjustment" is better.

2. Go Deep During Due Diligence

Don't just accept the most recent balance sheet at face value. You need to understand how cash actually flows through this business.

Pull at least three years of financial statements and calculate:

• Days Sales Outstanding (DSO) - How long does it take to collect from customers?

• Days Inventory Outstanding (DIO) - How long does inventory sit before being sold?

• Days Payable Outstanding (DPO) - How long before you need to pay suppliers?

• Cash Conversion Cycle - The complete picture of how long your cash is tied up

Look for trends. Is DSO increasing? That's a red flag that customers are slowing their payments. Is DIO going up? You might be holding obsolete inventory that won't convert to cash as easily as the balance sheet suggests.

3. Get a Quality of Earnings Report

A good QofE provider will normalize working capital and identify the true operating level the business needs. They'll catch things that aren't obvious:

• Seasonal fluctuations that mean the closing date matters enormously

• One-time balance sheet items that inflate or deflate the working capital picture

• Changes in payment terms with major customers or suppliers that alter working capital needs

• Industry-specific working capital cycles you might not understand as an outsider

4. Build Adjustment Mechanisms Into Your Purchase Agreement

Make working capital delivery subject to post-closing adjustment based on the final closing balance sheet. Here's how it typically works:

If the seller delivers less working capital than the target, they owe you the difference in cash. If they deliver more, you pay them the difference.

This creates the right incentive: the seller can't strip cash right before closing without writing you a check to make up for it.

The Cascading Cost of Getting This Wrong

Inadequate working capital doesn't just create short-term stress. It triggers a destructive chain reaction:

You can't grow. New customers require you to extend credit and carry additional inventory. Without working capital, you literally cannot afford to win new business.

Suppliers squeeze you. When you're slow to pay, suppliers tighten terms, remove early-pay discounts, or stop extending credit altogether. This further strains your cash position.

You're forced into expensive financing. Emergency capital is the most expensive capital. Whether it's a merchant cash advance, factoring at terrible rates, or giving up equity in a distressed deal, you'll pay dearly to fix a working capital crisis.

Growth stalls immediately. The business you just acquired becomes worth less the moment you own it because it can't operate normally, let alone grow.

Your lender gets concerned. If you financed the acquisition, your lender will notice immediately when the business isn't performing as projected. This can trigger additional scrutiny, covenant concerns, or worse.

Your Action Plan: Do This Before You Sign

Here's your step-by-step approach to avoid the working capital trap:

Step 1: Pull three years of balance sheets from the seller. Calculate the average working capital during normal operations. Exclude unusual periods like right after they made a large inventory purchase or received an abnormally large customer prepayment.

Step 2: Compare that historical average to what the seller projects will be on the balance sheet at your expected closing date. If there's a meaningful gap, you've found your problem before it becomes your problem.

Step 3: Build a working capital target into your LOI that reflects the actual operating needs of the business, not just what the seller wants to leave behind.

Step 4: During due diligence, validate your target by analyzing the cash conversion cycle and getting input from your QofE provider.

Step 5: Include a working capital adjustment provision in your purchase agreement with a dollar-for-dollar true-up mechanism.

Step 6: Have your accountant review the closing balance sheet carefully before you wire funds. This is your last chance to catch problems before they become your responsibility.

The Bottom Line

Every successful acquisition I've been involved with had working capital properly addressed from the LOI stage forward. Every post-closing disaster involved buyers who figured they'd "deal with it later" or assumed the seller would be reasonable about leaving adequate cash in the business.

Working capital isn't a detail to handle in the final week before closing. It's a fundamental component of deal structure that determines whether your acquisition succeeds or becomes a daily crisis.

Do the math now. Put it in writing. Get it right before you sign.

Your future self will thank you.

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