Lincoln International’s experts in M&A disputes outline how buyers and sellers can bridge the gap between target and closing net working capital.

The Limitations of Target NWC

How the target NWC is typically set

The target NWC is a normalized benchmark used to establish a reference level of working capital for purposes of the post-closing purchase price adjustment. In setting the target, parties often consider business seasonality or cyclicality and expected transaction close timing to estimate the anticipated level of NWC at closing. In that process, the buyer generally favors a higher target to increase the likelihood of a downward purchase price adjustment, while the seller generally favors a lower target to increase the likelihood of an upward purchase price adjustment.

Although the target NWC is intended to represent a “normal” level of NWC, the typical construction of the target NWC is based on financial diligence and negotiation rather than a rigorous accounting analysis. This introduces structural limitations from the outset.

The target NWC is often developed based, in part, on a QofE analysis, which typically focuses primarily on the target’s historical normalized income statements (i.e., to calculate adjusted EBITDA) and, secondarily, the target’s historical balance sheets. The target NWC is then typically calculated based on the target company’s average NWC balances over a 3-to-12-month lookback period, with the most common adjustments from historical balances for unusual, nonrecurring or non-operational items.¹

The final target NWC is commonly defined in the purchase agreement as a fixed number negotiated between the buyer and the seller without detail as to how that number was calculated. These factors serve to embed limitations into the resulting target NWC.

Challenges of common approaches to setting the target NWC

A QofE-derived target can serve as a building block to provide directional insight into normalized NWC of the target company, but it is not designed for the precision, verification and definitional clarity that parties seek for a post-close purchase-price mechanism due to the following reasons:

• Different focus: QofE analyses often focus on earnings sustainability rather than a detailed generally accepted accounting principles (GAAP) analysis of the balance sheet. A QofE analysis is not an audit and does not provide assurance as to the accuracy of the underlying financial statements.
• Limited verification: QofE procedures typically do not confirm the authenticity of documents provided by target company management, independently verify management’s statements or test for misstatements in target company financials.
• Non-quantified issues: QofE reports sometimes flag “non-quantified adjustments,” which are potential adjustments to earnings and the balance sheet that are often not quantified due to limited available information. Such amounts left unadjusted in the target NWC could result in post-close exposures.
• Negotiation noise: The final target NWC is often a negotiated number with no clear bridge between the analyzed data and the agreed peg, leaving ambiguity about what is “in” or “out.

Where the Target and Closing NWC Diverge

Differences in accounting rigor and contractual requirements frequently cause the target and closing NWC to measure different economic realities.

• Historical financial statements vs. GAAP: The calculation of the target NWC often begins with the target’s historical financial statements, which may be represented to be prepared in accordance with GAAP. However, these financials are not subjected to a full GAAP audit as part of a QofE. As a result, GAAP deviations embedded in the target company’s historical balance sheet may remain in the target NWC. At closing, however, the purchase agreement frequently requires the closing NWC to be prepared strictly in accordance with GAAP, bringing those deviations to the surface. Additionally, certain target company financials subject to diligence may be based on an interim (e.g., mid-year) reporting date which did not include a “hard close” of the accounting records for typical year-end GAAP adjustments.
  • Example: The seller historically expensed certain prepayments, and the resulting target NWC did not include prepaid expenses in its calculation. At closing, the buyer followed this historical treatment and expensed those costs in its calculation of the closing NWC. The seller objected and asserted that, under GAAP, the expensed costs should be capitalized as current assets, resulting in an upward purchase price adjustment.

• Framework mismatch: The target NWC is often based on GAAP or management-prepared financials (as adjusted), while the closing NWC follows the bespoke accounting principles in the purchase agreement—two sets of rules that will likely not yield the same answer.
  • Example: The target NWC reflected the company’s historical GAAP policies and did not include a rebate accrual based on management’s historical judgment. The purchase agreement required all rebates to be recorded as current liabilities at closing. The booking of the accrual reduced the closing NWC and resulted in a downward purchase price adjustment.

• Missed items and adjusting the target: Items excluded from the target NWC could be later swept into the closing NWC under broad definitions in the purchase agreement. When this happens, one party might argue that the target NWC itself should be revised to reflect the newly identified item. The counterparty typically responds that the target is a fixed, negotiated number and that the purchase agreement provides no contractual mechanism to retroactively adjust the target NWC, leaving the dispute to play out through the post-closing true-up.
  • Example: Sales-tax liabilities were excluded from the target NWC. At closing, the buyer recorded the liability under the purchase agreement’s broad definition of current liabilities, reducing the closing NWC. The seller argued that the target NWC should be revised for comparability; the buyer countered that the target NWC was fixed and this liability could only be trued up through the closing NWC, resulting in a downward purchase price adjustment and a dispute over contractual mechanics.

• Impact of seasonality: The target NWC is often calculated using a 3-to-12-month historical average, while the transaction may be expected to close at a seasonal high or low point in NWC. Whether and how to adjust the target for seasonality is frequently a point of contention, with buyers often advocating for a higher, seasonally adjusted target and sellers favoring a simple historical average. When seasonality is not explicitly addressed, the resulting target may embed a timing mismatch between the reference point and expected closing conditions.
  • Example: Before closing, the buyer proposed a seasonally adjusted target NWC based on the company’s expected inventory build at the anticipated closing date, while the seller advocated for a 12-month historical average that smoothed seasonal fluctuations. The parties ultimately negotiated a compromise target between the two positions.

Practical Tips to Bridge the Gap

While the structural differences between the target and closing NWC cannot be eliminated, buyers and sellers can reduce post-close risk by proactively aligning diligence findings with contractual accounting mechanics before signing.

• Understand what’s behind the peg: Reconcile the target NWC back to the source data used in the QofE. Identify which account balances were adjusted, excluded or simply carried over into the target NWC. Document whether potential “non-quantified” items flagged in diligence remain embedded in the target NWC, and whether the target NWC included seasonal adjustments. A clear trail prevents hearing “we thought it was included” post-close.
• Clarify consistency: Confirm whether the target and closing NWC will be calculated on the same accounting basis. If so, codify this treatment in an Accounting Principles schedule to the purchase agreement with an illustrative calculation of NWC.
• Incorporate diligence into definitions: Before signing, convert key QofE adjustments (e.g., reserves, accruals, cut-offs) into the accounting terms used in the purchase agreement. This will help to avoid disconnects later when the closing statement is prepared under specific principles in the purchase agreement.