Scott Foster · Shape Executive · EBITDA & Performance
Where The Value Transfer Actually Happens
When a founder sells a business, the number they focus on is the enterprise value. The multiple times the maintainable EBITDA. That is the number on the term sheet, in the heads of agreement, and in the conversations with advisers about whether the price is fair.
It is not the number they receive.
What founders actually receive is the equity value — enterprise value less net debt, adjusted for the working capital position at completion. For many founders, particularly those who have not been through a transaction before, the gap between enterprise value and equity proceeds is larger than they expected. And a significant portion of that gap is working capital.
Private equity firms understand this precisely. They have modelled it, negotiated it in dozens of transactions, and they know that working capital mechanics are frequently misunderstood by vendors. This is not a manipulation — it is arithmetic. But the founder who does not understand the arithmetic is at a structural disadvantage in the negotiation.
What Is Working Capital In A Business Sale?
The Mechanics Of The Working Capital Adjustment
Working capital in a business sale is defined as current assets less current liabilities — predominantly debtors plus inventory less creditors. The definition is agreed between buyer and seller as part of the transaction documentation, and the details of what is included and excluded matter significantly.
The buyer and seller agree on a target working capital level — the normalised level required to run the business at its current level of activity. If the actual working capital at completion is above the target, the seller receives the surplus. If it is below the target, the seller pays the shortfall from the sale proceeds.
The normalised level is derived from a historical average — typically twelve months, sometimes longer, sometimes adjusted for seasonality. The negotiation of the target, the measurement period, and the definition of what is included is technical, consequential, and frequently where founders are less well-prepared than the buyer.
A business that has been operated with chronically extended debtor days, excess inventory, or creditor terms that rely on supplier relationships rather than commercial substance will have a normalised working capital requirement that is higher than the founder expects. The adjustment at completion is the mechanism by which the buyer is protected from receiving a business with less working capital than it needs.
Why Private Equity Models Working Capital In Detail
Private equity firms model working capital at acquisition for three distinct reasons, each of which reflects a different dimension of what working capital tells them about a business.
As a completion mechanic. The working capital adjustment is a direct component of net proceeds. Modelling it accurately — understanding what the normalised level will be, how it will be measured, and where there is negotiating room — is a standard part of the investment analysis. PE firms that have done many transactions have seen every form of working capital dispute and they price accordingly.
As a cash flow lever. Working capital improvement is one of the first levers pulled in the early months of a PE holding. Reducing debtor days from sixty to forty-five across a business generating twenty million dollars of revenue releases significant cash — cash that can be used to fund growth, reduce debt, or support the broader value creation plan. The acquirer who buys a business with structural working capital inefficiency sees an immediate improvement opportunity that the vendor was not capturing.
As a quality signal. The working capital composition tells an experienced buyer something about how the business has been managed. A business with tight debtor days, well-managed inventory, and creditor terms that reflect commercial discipline is a business whose management has been paying attention to cash conversion. A business with chronically extended debtors, slow-moving inventory that has been carried for years, and creditor terms that depend on individual supplier relationships is a business where management has been focused on the P&L but not the cash flow. The latter is not just a working capital problem — it is a management quality signal.
The founder who focuses on enterprise value and ignores working capital mechanics is negotiating the headline price while the real proceeds are being determined elsewhere.
How Working Capital Affects Business Valuation
The Three Working Capital Problems Most Businesses Have
In the mid-market businesses I have worked through — either operationally or through a transaction process — the working capital issues that surface consistently are predictable. Not universal, but common enough to treat as a default assumption until proven otherwise.
Extended debtor days. Debtors are the most visible component of working capital and the easiest to manage — yet many businesses operate with debtor days that are significantly longer than their stated terms would suggest. The invoice is issued. The customer pays when they are ready. No one chases systematically because the relationship feels too important to strain. The result is a debtor book that is technically performing but practically slower than it should be. Reducing debtor days is the fastest, cheapest working capital improvement available to most businesses — and the improvement flows directly to cash.
Structural inventory excess. Inventory is harder to manage than debtors because it requires decisions about what to stock, how much, and at what reorder point. Many businesses carry inventory that is genuinely required for customer service alongside inventory that has accumulated over time — slow-moving lines, obsolete stock, safety stock levels that were set years ago and never reviewed. The carrying cost is an expense. The cash is tied up. The inventory turns number in the management accounts understates the problem because the slow-moving stock is not flagged separately.
Fragile creditor terms. The creditor side of working capital is often where the most fragile arrangements exist. Terms extended by suppliers based on a long-standing relationship with the founder. Payment cycles that have drifted beyond the contractual terms without formal renegotiation. Arrangements that work well for the current ownership but whose durability after a change of control has not been tested. A buyer who intends to renegotiate supplier terms to standard commercial conditions will find that the working capital position changes when those negotiations occur.
What To Do Before A Transaction
The working capital preparation that makes the most difference to transaction outcomes is not the preparation that happens in the months before a process begins. It is the operational discipline that is embedded over years and shows up in the historical periods that buyers will use to set the normalised target.
Systematically reducing debtor days — implementing debtor management processes, incentivising early payment, enforcing terms consistently — produces a working capital position that shows in multiple periods of accounts. The improvement is credible because it is demonstrated, not claimed.
Addressing inventory composition — identifying and liquidating slow-moving and obsolete stock, reviewing safety stock levels against actual demand, tightening reorder processes — reduces the carrying cost and improves the turns ratio. It also reduces the risk that a buyer's working capital assessment produces a large inventory write-down adjustment.
Understanding the fragility of creditor arrangements — identifying which terms are contractual and which are relational, renegotiating where possible to put arrangements on a formal commercial basis — reduces the risk that post-acquisition creditor renegotiations produce a working capital deterioration that the vendor had not anticipated.
And working through the mechanics of the completion adjustment before a process begins — understanding how the target will likely be set, what the normalised level is, and where there is room to influence the outcome — puts the vendor in a materially stronger negotiating position.
Frequently Asked Questions
Why is working capital important in a business sale?
Working capital matters in a business sale because it directly affects net proceeds through the completion adjustment mechanism, it signals operational discipline to buyers, and it is a lever for cash generation that PE acquirers model and act on immediately post-acquisition. Founders who do not understand the working capital mechanics of a transaction frequently discover at completion that their net proceeds are materially different from the headline enterprise value they negotiated.
What is a working capital adjustment?
A working capital adjustment is the difference between the actual working capital at completion and the normalised working capital target agreed between buyer and seller. If actual working capital is below the target, the seller pays the shortfall from the sale proceeds — reducing net equity value. If it is above the target, the seller receives the surplus. The target is derived from a historical average of working capital over an agreed period, adjusted for seasonality and normalised for any items excluded from the definition.
How do I improve working capital before selling a business?
The most effective working capital improvements are systematic debtor management to reduce debtor days, inventory rationalisation to remove slow-moving and obsolete stock and tighten reorder disciplines, and formalisation of creditor arrangements to put relational terms onto a commercial basis. These improvements take time to demonstrate credibly — the historical periods used to set the normalised working capital target need to reflect the improved position, which typically means starting two or more years before a planned transaction.