Introduction
Within lower middle market M&A transactions, few areas lead to more misunderstanding—or post-closing disputes—than working capital and earnout structures. While parties often believe they are aligned during negotiations, differences in interpretation frequently emerge after closing, when definitions are tested in practice.
This discussion outlines how working capital should be properly viewed in a transaction setting and examines how it intersects with contingent consideration mechanisms such as earnouts.
Rethinking Working Capital in a Transaction Context
One of the most persistent challenges in deal execution is establishing a clear and accurate working capital target. The difficulty does not stem from calculation alone, but from disagreement over what should be included in the first place.
Different stakeholders naturally approach working capital from different perspectives. Accountants tend to rely on standardized definitions, while operators, investors, and advisors focus more on how capital functions within the business. These differing viewpoints often lead to inconsistent assumptions early in the process.
Traditionally, working capital is defined as the difference between current assets and current liabilities. While this definition is technically sound, it is overly broad for transaction purposes, as it captures items that may not be directly tied to the company’s operations.
In an acquisition environment, particularly in the lower middle market, the emphasis shifts to operational relevance. The more meaningful metric isolates the assets and liabilities required to sustain ongoing business activity. Items such as excess cash, for example, are generally excluded because they represent liquidity rather than operational necessity.
As a result, practitioners focus on Net Operating Working Capital (NOWC), defined as operating current assets less operating current liabilities. This measure reflects the capital required to support revenue generation, including receivables, inventory, and the timing of payables.
Determining the appropriate composition of NOWC is often the most complex step. Once properly defined, historical performance can be used to establish a reasonable benchmark for the transaction.
Understanding the Composition of Working Capital
Working capital in a transaction can be viewed as having two distinct components.
The first is the operational component, which includes items such as accounts receivable, inventory, accounts payable, accrued expenses, and prepaid items. This represents the capital actively deployed in the business and is typically transferred to the buyer at closing.
The second is a broader, strategic component. This includes access to liquidity, credit capacity, and financial resources needed to support growth, absorb volatility, and fund future initiatives. Unlike operational working capital, this layer is generally provided by the buyer following the transaction.
Together, these components form a layered structure in which the buyer acquires the operating engine of the business but is responsible for ensuring it has sufficient financial capacity moving forward.
How Earnouts Influence the Equation
Earnouts are frequently used to address valuation uncertainty. When buyers and sellers cannot agree on the sustainability of future performance, contingent payments provide a mechanism to bridge the gap.
Introducing an earnout effectively splits the purchase price into two elements: a guaranteed portion and a performance-based component. The latter is only realized if predefined targets—such as revenue, profitability, or customer retention—are achieved.
While this structure can facilitate agreement, it also creates additional complexity when considered alongside working capital.
The operating needs of the business do not change simply because part of the purchase price is contingent. However, the allocation of risk does. This raises a fundamental question: Should a buyer receive the full level of working capital required to support the business if they are not committed to pay the full value upfront?
From a structural standpoint, providing full working capital in exchange for partially contingent consideration can create an imbalance. If a portion of the purchase price is uncertain, it may be appropriate to adjust the level of working capital delivered to reflect only the value that is guaranteed at closing.
Misalignment often arises when earnouts are layered onto a transaction without revisiting the working capital framework. Addressing both elements together is essential to maintaining economic consistency.
Situations Where Earnouts Are Common
Earnouts tend to appear in transactions where future performance is difficult to predict with confidence. Common scenarios include:
- Businesses experiencing rapid or recent growth
- Companies recovering from temporary disruptions
- Revenue models with significant customer concentration
- Organizations reliant on key relationships or referral channels
- Periods of broader economic uncertainty
In these cases, buyers seek protection against downside risk, while sellers aim to capture the full value of anticipated performance. Earnouts serve as a compromise between these competing objectives.
Why Working Capital Adjustments Lead to Disputes
Even in well-structured transactions, working capital adjustments are a frequent source of post-closing disagreement.
Most deals include a reconciliation period after closing, during which the buyer assesses whether actual working capital aligns with the agreed target. Differences in methodology, assumptions, or timing can quickly lead to disputes.
Tension arises regardless of the direction of the adjustment. If the seller is required to return funds, or if the buyer must make an additional payment, the likelihood of conflict is high. This reinforces the importance of clearly defining all components and methodologies prior to closing.
Accounting for Seasonality
Seasonal fluctuations further complicate working capital analysis. Many businesses experience predictable variations throughout the year, whether due to industry cycles, customer behavior, or external factors.
This variability creates a timing issue: the level of working capital at closing may differ significantly depending on when the transaction occurs within the cycle.
A sound approach is to base the working capital target on normalized levels that reflect the activity used to determine valuation. This ensures that neither party is advantaged or disadvantaged by the timing of the transaction.
Failure to adjust for seasonality can distort the economics of the deal. Overestimating working capital benefits the buyer, while underestimating it shifts additional funding requirements to the buyer after closing.
Aligning Earnouts and Working Capital
When both earnouts and seasonality are considered, two common structuring approaches emerge.
The first approach ties the working capital delivered at closing to the portion of the purchase price that is fixed. Under this model, the buyer receives only the level of working capital necessary to support the performance they have paid for upfront. Any additional capital required to achieve earnout targets is funded through future operations or additional investment.
The second approach involves delivering a fully capitalized business at closing, including working capital sufficient to support both current operations and potential earnout performance. In this case, a mechanism is established to compensate the seller if earnout targets are not achieved, effectively reallocating the risk associated with the contingent portion.
Both approaches can be effective, but each requires clear documentation and alignment between the parties.
RBA’s Role in Structuring Alignment
Our experienced advisors play a critical role in bridging the gap between theory and execution. Our value lies not in advocating for one side, but in ensuring that the structure of the transaction reflects economic reality.
This includes identifying when earnouts disrupt traditional assumptions, distinguishing between operational and growth-related capital, incorporating seasonality into analysis, and addressing potential areas of disagreement before they escalate.
Transactions in which working capital and earnouts are negotiated independently often encounter avoidable friction. Integrating these discussions leads to more efficient processes and smoother outcomes.
Conclusion
Working capital and earnouts are often treated as separate elements of a transaction, but in practice they are closely linked.
A well-structured deal ensures that the capital transferred at closing corresponds to the value being paid, that the business is positioned to operate effectively, and that risk is allocated in a balanced manner.
In the lower middle market, successful outcomes are rarely driven by headline valuation alone. Instead, they depend on thoughtful structuring, beginning with a clear understanding of how much capital the business truly requires to operate and grow.
