What is Working Capital?
In its simplest form, working capital is the difference between what your business owns (current assets) and what it owes (current liabilities). For most businesses, this includes: The SBA's financial management guidance notes that working capital disputes are one of the top three sources of post-closing litigation in small business M&A -- making clear contractual definitions critical.
- Current assets: cash, accounts receivable (AR), and prepaid expenses
- Current liabilities: accounts payable (AP), accrued expenses, and deferred revenue
Working capital = Current Assets - Current Liabilities
In agency M&A, working capital is critical because the buyer expects to receive a certain amount of working capital with the business. Unlike physical assets or equipment, working capital fluctuates daily based on client billing, vendor payments, and cash inflows.
When you sell your agency, the purchase agreement typically includes a "target" or "peg" for working capital. At closing, an adjustment is made if the actual working capital you deliver differs from the peg. This adjustment flows directly to your proceeds or is owed back by you.
The Working Capital Peg
The "peg" is the working capital baseline agreed upon in the purchase agreement. It's usually calculated one of two ways:
Method 1: Percentage of Revenue
The buyer might specify that working capital should equal 15 days of revenue, or 5% of annual revenue. For a $10 million revenue agency, 5% working capital would be $500,000.
This method is straightforward but can be unrealistic if your agency has seasonal patterns or unusual billing practices.
Method 2: Historical Average
The buyer analyzes your last 12-24 months of working capital and uses the average as the peg. This is more nuanced and account for your specific business patterns.
For example, if your average working capital over the past 18 months was $480,000, that becomes the peg.
Negotiation point: Pegs are negotiable. If the buyer's proposed peg seems unrealistic given your billing practices, push back with historical data. A lower peg is better for you because it means less downside risk in the post-closing adjustment.
How the Working Capital Adjustment Works
Let's walk through a real example to see how this plays out at closing and beyond.
Scenario: You're selling your $10 million revenue agency for $3 million. The purchase agreement sets the working capital peg at $500,000 (5% of revenue).
On closing day, your balance sheet shows:
- Accounts Receivable: $320,000
- Deferred Revenue: $180,000
- Accounts Payable: -$50,000
- Accrued Expenses: -$100,000
- Actual Working Capital: $350,000
Since you're delivering $350,000 in working capital but the peg was $500,000, you're $150,000 short. The purchase agreement likely includes a formula for how this is handled:
- Option A (Dollar-for-dollar adjustment): The purchase price is reduced by $150,000. You receive $2.85 million instead of $3 million.
- Option B (Post-closing settlement): You pay the buyer $150,000 within 30-60 days after closing if the final true-up shows you were short.
- Option C (Escrow holdback): $150,000+ is held back from your proceeds in escrow for 6-12 months and released once the working capital is verified.
Conversely, if you deliver $650,000 in working capital (excess of $150,000), you would receive an additional $150,000 payment, or that amount would be held in escrow in your favor.
What's Included in Agency Working Capital
The purchase agreement defines exactly what counts toward working capital. The definition varies, but typically includes:
Accounts Receivable (AR)
This is money your clients owe you for work completed. The buyer wants to ensure they're receiving AR that's actually collectible. Most agreements include a "quality of earnings" clause that allows the buyer to exclude questionable AR or adjust for historically uncollectible amounts.
Common issue: If you have large AR from a few key clients and those clients have payment issues, the buyer may discount or exclude that AR from working capital.
Deferred Revenue
This is cash you've collected from clients for work you haven't yet completed. It's a liability on your balance sheet but a critical component of working capital because it represents cash that's already in the bank.
Common issue: How deferred revenue is recognized varies widely in agencies. Some agencies record retainers upfront; others amortize them monthly. Disagreements about deferred revenue treatment are the #1 source of working capital disputes.
Pro tip: If you use retainers or deferred revenue heavily, document your accounting treatment thoroughly before the buyer's accountants review it. Having a clean, auditable trail reduces post-closing disputes by 70%.
Accounts Payable (AP)
Money you owe to vendors, contractors, or service providers. This is included as a liability that reduces working capital. The buyer expects AP to be current and accurate.
Common issue: Some sellers artificially defer payables near closing to inflate working capital. Don't do this—it will be caught in due diligence and will damage trust.
Accrued Expenses
Salaries, benefits, payroll taxes, bonuses, and other costs accrued but not yet paid. These reduce working capital and are critical to get right.
Common issue: If you have unpaid bonuses, deferred compensation, or other accrued liabilities, make sure these are documented and included. Buyers will hunt for these.
What's Typically Excluded
Working capital definitions usually exclude:
- Cash: Transferred separately at closing
- Debt: Refinanced or paid down at closing
- Fixed assets: Equipment, software, leasehold improvements
- Intangible assets: Goodwill, customer relationships (valued separately)
- Owner distributions: Final bonuses or dividends to shareholders
Why Agencies Have Working Capital Disputes
Marketing agencies are particularly prone to working capital disagreements for a few reasons:
Reason 1: Revenue Timing and Billing Practices
Agencies often use retainers, project-based billing, or hybrid models. A client might pay $50,000 upfront for a 3-month project. This creates deferred revenue that fluctuates based on when projects start and end.
If closing happens mid-month, mid-project, the deferred revenue number can swing wildly. What counts as deferred revenue—the full retainer, or only the unearned portion?
Reason 2: Client Concentration
If a significant portion of your AR comes from 2-3 large clients, the buyer may challenge the collectibility of those receivables. One large client default or slowdown can cause working capital to miss the peg by hundreds of thousands.
Reason 3: Seasonal Patterns
Many agencies have busy and slow seasons. If closing happens in a slow season, AR will be lower and deferred revenue might be minimal. The buyer didn't account for this and may claim you're short on working capital.
Reason 4: Accounting Ambiguity
If your accounting practices are loose—especially around revenue recognition, AR aging, or accrued expenses—the buyer's accountants will interpret everything in the most conservative way possible, reducing your working capital.
Reason 5: Post-Closing Performance
Even if closing-day working capital is accurate, the true-up process (which happens 60-90 days after closing) can reveal additional issues. Client AR you thought was collectible turns out to be bad. A retainer client doesn't renew. Payables you thought were accrued weren't.
How to Prepare for Working Capital Adjustments
The goal is to minimize surprises and disputes. Here's how:
Step 1: Understand the Purchase Agreement Language
Before signing LOI, scrutinize the working capital definition. Work with your attorney to ensure it's fair and based on your actual business practices. Negotiate the peg if it seems unrealistic.
Step 2: Audit Your Accounting
Hire your accountant to conduct a pre-closing cleanup:
- Reconcile all balance sheet accounts
- Age the AR report and identify any uncollectible amounts
- Review deferred revenue; document the accounting policy
- Ensure all accrued expenses are properly recorded
- Verify AP is current and complete
- Look for unusual transactions or timing issues
Step 3: Provide Historical Trends
Pull 12-24 months of monthly balance sheets and calculate working capital for each month. Show the buyer the historical range and explain any patterns or seasonality.
Example: "Our working capital ranges from $400K in Q4 to $550K in Q2 due to project-based revenue and retainer seasonality. We're targeting $480K at close, which is our 18-month average."
Step 4: Create a Closing Balance Sheet
In the final 30 days before closing, work with your accountant to prepare a pro-forma closing balance sheet based on the expected closing date. Share this with the buyer. If there are concerns, address them early rather than at closing.
Step 5: Document Billing Practices
Create a written memo documenting how you handle:
- Retainer invoicing and recognition
- Project-based revenue recognition
- AR write-offs and bad debt policy
- Deferred revenue accounting
- Accrual policies for bonuses, payroll taxes, etc.
This prevents the buyer from second-guessing your accounting after the fact.
Step 6: Hire Quality Advisors
Don't cheap out on your accounting advisor. A good advisor will catch issues before the buyer does, suggest balance sheet optimization strategies, and represent you in post-closing true-up discussions.
- Median WC Adjustment: In agency M&A, the median working capital adjustment is 3-5% of purchase price, split roughly evenly between buyer and seller adjustments. This is one of the most common sources of post-closing friction.
- Dispute Rate: Approximately 40% of agency M&A deals experience working capital disputes that require negotiation post-closing. Having clean accounting reduces this risk significantly.
- Resolution Time: Working capital disputes can take 3-6 months to resolve if they require third-party arbitration or expert determination. Budget time and legal fees accordingly.
- Escrow Holdback: Most purchase agreements include an escrow holdback of 10-15% of purchase price for 12-18 months to cover potential working capital adjustments, indemnification, and earn-out obligations.
Typical Working Capital Peg Negotiations
When negotiating the working capital peg with the buyer, keep these benchmarks in mind:
Service-Based Agencies (Retainer-Heavy)
Working capital peg: 10-20 days of revenue. Service agencies with predictable monthly revenue need less working capital than those with project-based billing.
Project-Based Agencies
Working capital peg: 20-40 days of revenue. More volatile revenue patterns require higher working capital to buffer operations.
Agencies with Large Upfront Retainers
Working capital peg: Negotiated as a fixed dollar amount, not a revenue percentage. Because deferred revenue is lumpy, a percentage-based formula doesn't work well.
Agencies with Seasonal Revenue
Working capital peg: Usually negotiated based on the average of the busiest and slowest quarters, or locked in at the planned closing date (e.g., "Q2 closing with Q2 average working capital").
Strategy: If the buyer proposes a peg that seems high based on your history, propose using your actual 12-month average instead. Most buyers will accept this because it's objective and defensible.
The Post-Closing True-Up Process
After closing, the buyer's accountants will recalculate working capital based on the actual closing-day balance sheet and applicable purchase agreement definitions. This is called the "true-up."
The timeline typically works like this:
- Closing day: Preliminary closing balance sheet provided
- 30-60 days post-close: Buyer's accountants audit the closing balance sheet
- 60-90 days post-close: Final working capital calculation and adjustment memo sent to seller
- 90-120 days post-close: Seller has opportunity to dispute findings and provide supporting documentation
- 120-180 days post-close: Disputes are resolved through negotiation or, if necessary, third-party expert determination
During this time, cash from the true-up (if in seller's favor) is typically held in escrow pending resolution of other indemnification claims.
Red Flags to Avoid at Closing
Don't do any of these things as you approach closing:
- Artificially lower payables: Delaying vendor payments to reduce liabilities. The buyer will catch this and may require you to pay bills post-closing.
- Pull forward deferred revenue: Recognizing deferred revenue early to inflate assets. Inconsistent with your historical accounting and will be challenged.
- Hold back bonus accruals: Not accruing earned bonuses to inflate working capital. These will be caught and you'll owe the money anyway.
- Write off AR too aggressively or too conservatively: Any significant change from historical practice will raise red flags. Be consistent.
- Fail to accrue for known obligations: If you know a liability exists, you must accrue for it. Omitting known liabilities is fraud.
LPP's Approach to Working Capital in Acquisitions
Lightning Path Partners structures acquisitions with clear, defensible working capital pegs based on historical analysis. We work with your accountants to ensure the closing balance sheet is clean and auditable, which minimizes post-closing disputes.
Because we're building a long-term rollup platform, we're not looking to nickel-and-dime sellers with aggressive working capital adjustments. We want clean, straightforward closings that allow sellers to deploy capital with confidence.
The Bottom Line
Working capital is not exotic—it's just the operating cash your business needs on a daily basis. The key to avoiding disputes is understanding the peg, getting your accounting clean, documenting your practices, and working transparently with the buyer throughout due diligence.
Don't try to game the working capital calculation. It will backfire. Instead, ensure your accounting is honest and auditable, negotiate a fair peg upfront, and prepare thoroughly for the closing true-up process.
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