Working capital is where a lot of buyers quietly overpay. You agree on a headline price, everyone feels good, and then right before closing the peg conversation surfaces and you discover you’re funding yesterday’s receivables with tomorrow’s equity. Normalizing working capital early keeps cash in your pocket, prevents last-minute drama, and makes post-close life a lot calmer. Here’s a practical guide that you can use pre-LOI through close.
What “normalized working capital” actually means
Normalized working capital is the amount of day-to-day liquidity the business truly needs to operate—not the balance on one random day. In SMB deals, it’s usually defined as AR + Inventory – AP (plus or minus a few agreed current items), measured on a consistent, accrual basis. You’ll use this definition to set a peg (target) for closing and a true-up after close. Get the definition and method in writing early; vague terms are what cause midnight fights.
Why it matters
- It directly affects cash at close and the equity check.
- It prevents paying for temporary boosts (stretching AP, collecting AR early).
- It sets expectations so neither side feels retraded at the finish line.
Step 1: Decide the definition
Start by agreeing on the formula and what’s in vs. out.
Core formula (common in SMB)
- Include: Accounts Receivable (trade), Inventory (usable), Accounts Payable (trade).
- Often include/exclude by case: accrued expenses, customer deposits/deferred revenue, prepaid expenses, short-term portions of long-term contracts.
- Exclude: unrelated current items and one-off liabilities that aren’t part of day-to-day operations.
The key is alignment. If the business bills annually up front, for example, it’s common to exclude deferred revenue from the peg and handle it separately with price mechanics or a debt-like adjustment tied to cost-to-fulfill. Documenting this early avoids double-counting cash or obligations later.
Step 2: Build a trailing view (not a point-in-time guess)
A single month is noise. Use a trailing average that reflects seasonality and business rhythm.
Practical approach
- Pull TTM monthly balances for AR, Inventory, and AP.
- Adjust for clear anomalies (e.g., a strike, a fire, a one-time buy).
- Calculate the average (or seasonally appropriate average if renewals are lumpy).
- Sanity-check against revenue cycles: busy season vs. slow season.
Using a trailing average is now standard practice in many SMB negotiations; it’s the simplest way to protect both sides from timing games.
Step 3: Clean the inputs so the peg reflects reality
Not all AR, inventory, or AP should count dollar-for-dollar.
Accounts Receivable
- Age it. Discount or exclude amounts over a defined threshold (e.g., >90 days) unless recoverability is proven.
- Related-party or employee receivables usually don’t belong in operational working capital.
- Credit memos/offsets: net them properly so you’re not counting phantom receivables.
Inventory
- Obsolescence and excess: remove or mark down dead stock; use historical write-offs or physical counts to support the adjustment.
- Consigned/held-for-others: exclude anything the company doesn’t own.
Accounts Payable
- Normalize payment practices. If the seller stretched payables in the run-up to close, don’t let that artificially lower the peg.
- Non-trade liabilities (e.g., taxes, bonuses) belong in separate buckets, not as a way to “juice” AP.
A good QoE will do this tie-out and present a recommended peg with adjustments; that schedule becomes your exhibit for the LOI and purchase agreement.
Step 4: Write it into the LOI (yes, this early)
Working capital rarely gets easier later. Put the method, measurement date, and true-up in your LOI so no one is surprised in the APA. At minimum include:
- Definition: “Working capital = AR + Inventory – AP (as defined), excluding [list].”
- Peg method: “Based on trailing 12-month average (or seasonally adjusted average).”
- Collar: “±$[amount] collar around the peg.”
- True-up: “60-day post-close true-up based on the closing balance sheet.”
Doing this upfront is one of the simplest ways to avoid last-minute renegotiation and protect buyer/seller goodwill.
Step 5: Handle tricky items the right way
Some balance-sheet items look like working capital but behave differently.
Deferred revenue / customer deposits
Prepayments suppress AR and inflate a liability for work still owed. Common treatments:
- Exclude from the peg, and agree to a debt-like adjustment equal to the cost-to-fulfill (not the full balance) at close; or
- Leave out of both peg and debt-like, if immaterial and stable.
Pick one approach and document it; the goal is to avoid paying twice.
Accrued expenses and payroll
If recurring and operational, they often belong in the definition. Just be consistent: include them in both the trailing average and closing measurement so you’re not cherry-picking.
Seasonality and renewals
Where revenue clusters (e.g., January SaaS renewals), consider a seasonally adjusted peg or use the average but time the measurement date to avoid penalizing either party.
Step 6: Agree on mechanics for the closing true-up
The peg is the target; the closing working capital is what you actually inherit.
Mechanics to spell out
- Calculation source: the closing balance sheet prepared under consistent accounting policies.
- Review window: buyer prepares or reviews; both parties reconcile within 45–60 days.
- Settlement: cash up/down against the purchase price; no surprises.
- Dispute resolution: simple process (auditor or agreed third party) with a short timeline.
Crisp mechanics turn a potentially emotional conversation into a math problem.
How normalization ties back to valuation and structure
Working capital is not just a closing-table footnote—it’s real money.
- Peg too high? You bring extra cash to close.
- Peg too low? You inherit a liquidity gap and start life as owner playing catch-up.
- Volatile balances? Use a wider collar, build an escrow, or offset with structure (e.g., a bit more seller note, slightly less cash at close) so both sides share the swing risk.
If your QoE lowers Adjusted EBITDA and shows weak working capital health, don’t just move price, consider seller financing or a holdback so risk and cash timing are aligned with reality.
Common mistakes (and easy fixes)
Treating a clean QoE as “all clear”
Even good businesses can have spiky working capital needs. Confirm the peg and collar; don’t assume.
Arguing definitions at the 11th hour
Set the formula in the LOI. Late changes feel like retrading and burn goodwill.
Ignoring AR quality
Aged AR isn’t as good as cash. Discount it or exclude it from the peg unless recovery is proven.
Counting inventory that won’t sell
Mark down obsolete or excess stock before it hits the peg. Your future self will thank you.
Letting AP games lower the peg
If the seller suddenly starts paying vendors in 60–90 days instead of 30, normalize back to the historic cadence.
Sample LOI language
Working Capital Definition & Peg
“Working capital means current assets consisting solely of trade accounts receivable and inventory minus current liabilities consisting solely of trade accounts payable, as presented in accordance with the Company’s historical accounting policies applied consistently. For the avoidance of doubt, deferred revenue, income taxes payable/receivable, and related-party balances are excluded. The working capital peg shall equal the trailing 12-month average as of the month immediately preceding closing, with a ±$[collar] collar and a 60-day post-close true-up.”
Deferred Revenue Mechanics
“To the extent closing deferred revenue relates to undelivered obligations, the parties agree to a cost-to-fulfill adjustment of [X]% of the related balance, treated as a debt-like item for purposes of the closing cash calculation.”
A quick case to make the math real
Facts
- $5.5M revenue; inventory-heavy services business.
- Trailing monthly averages: AR $650k, Inventory $900k, AP $700k → peg = $850k.
- Closing balance shows AR $720k (with $120k >90 days), Inventory $1.05M (includes $150k slow-moving), AP $820k (seller stretched terms pre-close).
Normalization
- Discount aged AR by 50%: count $60k instead of $120k.
- Remove slow-moving inventory $150k from the peg base.
- Normalize AP back to historical cadence: reduce AP $120k.
Adjusted closing working capital = ($720k − $60k) + ($1.05M − $150k) − ($820k − $120k)
= $860k (vs. peg $850k) → within a ±$100k collar, no cash moves.
Without normalization, you’d have counted questionable AR, dead stock, and stretched AP—swinging the true-up by >$300k. This is why you define and clean the peg early.
Buyer checklist: normalize working capital the right way
- Define early: formula, inclusions/exclusions, and measurement method in the LOI.
- Use a trailing average: TTM monthly balances; adjust for anomalies and seasonality.
- Scrub the inputs: aged AR, obsolete inventory, and AP timing games.
- Set mechanics: a reasonable collar and 60-day true-up with a simple dispute process.
- Handle tricky items: exclude deferred revenue from peg; address via cost-to-fulfill or other price mechanics.
- Align structure: if volatility is real, use seller notes/escrows to share risk rather than pretending it doesn’t exist.
Closing thought
Normalizing working capital isn’t about haggling; it’s about agreeing on how the business actually runs and making sure cash moves match that reality. Do the definition work now, anchor the peg in a fair trailing view, and write clean mechanics into your LOI. That way, closing is just math—not a fire drill.
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