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In startup acquisitions, buyers often overlook the significance of working capital (WC) which has a notable impact on the final proceeds. The adjustments made to WC are crucial for ensuring that the business can continue to operate after the sale is completed as they directly impact the amount of money that founders receive from the sale transactions. Founders must be well prepared for WC negotiations to steer clear of twists and ensure a fair outcome.

What Is Working Capital, and Why does it matter?

Working capital is the difference between current assets (like receivables and inventory) and current liabilities (such as payables and accrued expenses). It’s a measure of a business’s short- term liquidity and ability to meet operational needs.

In M&A deals, transactions are typically “cash-free, debt-free,” meaning sellers keep excess cash and settle outstanding debt. However, buyers expect the business to have enough WC at closing to operate smoothly. This required amount, called the “working capital peg,” is critical to negotiations. Think of it like passing a baton in a relay race—you need to leave enough momentum for the next runner (the buyer) to keep going without stumbling.

How the Working Capital peg works

The working capital peg represents the level of working capital (WC) that the purchaser anticipates receiving upon acquisition handover. During the finalization stage of the transaction process, your actual WC is evaluated against this target figure, with any variance resulting in modifications or adjustments.

To pilot startup acquisitions, founders should get a master working capital dynamics to ensure optimal value realization and sustained growth

If the peg is $500K and your working capital at handover is $350K, you will have to cover the $150K deficit.

If you deliver $650,000, the buyer owes you $150,000.

To avoid minor disputes, you can negotiate a collar, which creates a buffer range (e.g., $30,000 above or below the peg) where no adjustments are made.

Unique challenges for startups

Startups have unique WC challenges due to their evolving stage and operating models:

1.Seasonality and Growth:

Seasonal businesses or rapidly growing startups may see fluctuating WC needs. For example, an e-commerce startup might stockpile inventory ahead of an anticipated sales boom, temporarily increasing WC. Make sure that the peg reflects these cycles.

2.Deferred Revenue:

SaaS companies often collect upfront payments resulting in deferred revenue (a liability). Buyers might view deferred revenue as "debt-like" and exclude it from WC, reducing your proceeds. Clarify this early in the negotiation process.

3.Cash-Intensive Models:

Businesses that require substantial upfront expenses, like manufacturing startups, must ensure that these operational realities are factored into the peg to minimize financial deficits.

How founders can protect themselves

1.Engage Expert Advisors:

M&A advisors who have experience in WC adjustments can assist in navigating complexities and also in negotiating favorable terms.

2.Push for Specific Terms in the LOI:

Ensure the Letter of Intent (LOI) clearly explains how the peg will be calculated, whether based on averages from the last 3/6/12 months, and addresses disputed items like deferred revenue or customer deposits.

3.Negotiate a Collar:

Negotiate a buffer zone with a collar to prevent variations in WC resulting in significant financial adjustments.

4.Maintain Clean Financial Records:

Accurate records, including inventory schedules, accounts receivable aging, and payables reports, are essential for setting an appropriate peg and minimizing disputes during diligence.

5.Plan for Post-Closing Reconciliation:

After the deal closes, buyers often reassess WC to verify it aligns with the peg. Include clear terms in the purchase agreement to handle disagreements, such as engaging a neutral accounting firm.

The bottom line

Founders must skillfully handle working capital to secure an acquisition outcome where the payout aligns with the business's value creation efforts. It's more than just crunching numbers but a crucial financial aspect that significantly impacts the final deal for founders. Taking a strategic approach to managing working capital and setting negotiation terms can protect the founders’ hard earned financial gains and will ensure the transaction accurately represents the operational realities of their business.