In most small business acquisitions, everyone focuses on deal structure and taxes early in the negotiation process. What often gets overlooked — and what frequently causes friction late in the process — is working capital.

If you’re buying or selling a business, understanding how working capital fits into the deal can make the difference between a smooth closing and a frustrating renegotiation (or worse, a deal that quietly becomes more expensive than expected).

This article breaks down, in plain English, what working capital really is, why it matters, and the most practical ways to handle it in small business M&A.

What Working Capital Really Represents

Working capital is commonly defined as current assets minus current liabilities. But that definition misses the point.

In a functional sense, working capital is the lifeblood of the business. It’s the cash tied up in normal operations — the money needed to make payroll, buy inventory, pay vendors, and keep the lights on. Without it, the business stalls or must leverage to continue.

A simple way to think about it:

If you bought a landscaping business but the seller took all the fuel, mulch, and cash out of the register before closing, you’d be writing checks immediately just to complete the first week of jobs. That outlay becomes, effectively, part of your real purchase price.

The problem compounds if customers prepaid for services and the seller has deferred revenue that may or may not be accurately recorded.  I will address this in greater detail below.

Buyers Are Paying for a Functioning Business

Most buyers’ valuations assume the business operates normally with the right mix of inventory, receivables, prepaid expenses, and liquidity to support its historical revenue. If a seller removes too much working capital, the buyer must inject their own money to get the business back to normal operating levels. Economically, that is no different than increasing the purchase price.

This is why many buyers expect the business to be delivered with a “normal” or “baseline” level of working capital at closing.

Defining “Normalized Working Capital”

Normalized working capital is not derived simply from a snapshot of the balance sheet. Sellers often run lean or hold more cash than necessary for reasons that have nothing to do with operational needs.

Normalization looks instead at what the business requires to operate predictably:

• Average payroll and expense timing
• How quickly receivables convert into cash
• How long inventory sits or becomes obsolete
• When are suppliers paid
• Seasonal or cyclical patterns

This analysis arrives at an average level of working capital needed for a period of months to run smoothly, which is the baseline buyers typically want delivered, regardless of how the seller chose to manage their accounts.

What Typically Counts as Working Capital

Working capital is built from two buckets: current assets and current liabilities. Because these definitions affect the economics of the deal, they’re often the source of negotiation.

Common Current Assets:

• Accounts receivable (sometimes subject to aging thresholds)
• Inventory
• Prepaid expenses
• Certain deposits
• Sometimes cash, but many deals exclude cash by agreement

Common Current Liabilities:

• Accounts payable
• Accrued payroll and benefits
• Accrued taxes
• Short-term obligations
• Deferred revenue – this is critically important

Even small changes in these definitions can shift the value being transferred, so clarity in the definitive agreements helps avoid late-stage disputes.

Why Deferred Revenue Deserves Special Attention

Deferred revenue is money collected for services the business has not yet performed. In a service-heavy or subscription model, this number can be significant.

This is often compounded when the Seller is a cash basis taxpayer and has historically considered the prepaid revenue as available for cash flow needs prior to being “earned”.  This is often the case when revenue concentration is seasonal.

If mishandled, it becomes a trap for buyers where the seller receives the cash and accounts for it as earned, but the buyer inherits the work without the economic value.  Meaning the buyer effectively performs services for free. For that reason, deferred revenue is one of the biggest risks in small business M&A, and it should be addressed explicitly and early in the LOI negotiation and diligence process.

How Traditional M&A Handles Working Capital

In middle-market transactions, working capital is handled through a multi-step true-up process:

1. The parties calculate a normalized target based on trailing averages.
2. At closing, the seller delivers an estimated working capital amount.
3. Post-closing, the parties true up the final number and adjust the purchase price accordingly.

This system works well in larger deals with sophisticated accounting support.  But in smaller deals, this process can sometimes be too cumbersome if the parties do not focus enough effort on this analysis from the start or if available cash doesn’t cover necessary payoffs for closing.

Because of this, sometimes it makes sense to explore other more practical solutions once the parties have a baseline understanding of the working capital position.  Often this becomes a negotiation on the reduction of purchase price to coincide with the capital need.

How Businesses Should Think About Working Capital

Many closely held businesses, from service businesses to manufacturers, operate on thin working capital.  Owners often keep cash low for myriad reasons.

This means:

• Buyers must confirm that the business can operate on day one and for month one without a cash infusion.
• Buyers do not want to be responsible for collecting Seller’s receivables but need sufficient cash to survive until their receivables from operations post-closing are paid.
• Sellers should understand that stripping too much working capital can kill a deal or reduce price.
• Both parties must understand when cash in the bank account (or even worse already spent) is not yet “earned”.
• Both parties benefit from addressing this early in the diligence process.

Final Thought

Understanding the target business working capital needs is critical to deal success.  Inherent in that analysis is the normalization process discussed above and identifying whether the seller is accurately accounting for deferred revenue if it exists in their operations.  

In smaller business deals, if you don’t have enough working capital, you’ll have to inject it into the business, increasing the purchase price.  Keep the discussion on this topic practical and work with the counterparty to arrive at an economic arrangement that is fair to both sides and keeps the deal momentum moving forward.

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