Net Working Capital: How to Avoid Overpaying When Buying a Small Business
When you decide to buy a business, you are fundamentally buying one thing: a stream of future cash flow. The price you agree to pay—the Enterprise Value (EV)—is your valuation of that stream. But here lies the single most common and costly trap for inexperienced buyers: assuming that price tag is the only capital you’ll need.
A business is like a machine designed to produce cash. The EV is the price of the machine itself. But just like any machine, it needs fuel to run. In a business, that fuel is working capital. Failing to ensure the business is delivered with a full tank of fuel—what we call the Net Working Capital Target—means you've either overpaid for the business or you're about to stall out on day one.
What Exactly Is Working Capital?
At its simplest, working capital is the difference between a company's short-term operational assets and its short-term operational liabilities.
Current Assets: This is primarily Accounts Receivable (AR) (money customers owe you), Inventory, and the cash needed for daily operations.
Current Liabilities: This is mainly Accounts Payable (AP) (money you owe suppliers) and other short-term obligations like customer deposits or deferred revenue.
The problem is that in small private companies, the owner often manages working capital based on their personal cash needs, not the operational needs of the business. They might pull out too much cash or delay paying suppliers. This means the balance sheet on any given day doesn't reflect the actual amount of capital required to run the business smoothly.
This is where the concept of a Net Working Capital Target comes in. The Target is the specific, negotiated dollar amount of working capital a buyer needs to run the business post-closing without immediately having to inject more money. It's the core level of operating capital that is just as critical to generating cash flow as the company's equipment or customer lists.
Calculating Your True Investment
Because a seller's balance sheet is often unoptimized, a buyer cannot take it at face value. You must "normalize" it to determine the true Net Working Capital Target required to operate without disruption.
The operating capital gap (the cash needed for AR and inventory) is typically bridged by three sources:
Bank Financing: A bank will often provide a Line of Credit (LOC) against your current assets. A common rule of thumb is that they will lend up to 75% of the value of quality AR and up to 50% of the value of sellable inventory.
Trade Credit: Your suppliers provide a form of financing when they give you 30 or 60 days to pay your bills (Accounts Payable). An important piece of due diligence is confirming that your key suppliers will extend the same credit terms to you as the new owner.
Owner's Equity (The Target Gap): The gap that remains after exhausting bank and trade financing is the amount of the Net Working Capital Target. This is the capital that you, the new owner, must have in the business.
Let's say a business needs $200,000 in AR and inventory to run. The bank will lend $125,000 against it, and suppliers provide $25,000 in trade credit. That leaves a $50,000 gap. That $50,000 becomes the Net Working Capital Target. If you pay the seller the full Enterprise Value but the business is not delivered with that $50,000 in net working capital, you have effectively overpaid. Your total investment is now the EV plus the $50,000 you must immediately inject just to keep the lights on.
How to Protect Yourself in the Deal Structure
Understanding the concept is one thing; protecting yourself legally is another. How you address the Net Working Capital Target depends heavily on the deal structure.
In an Asset Sale: The buyer is purchasing specific assets, and the seller typically keeps their cash and AR. In this case, the purchase price for the assets must be explicitly calculated by deducting the required Net Working Capital Target from the Enterprise Value. If the EV is $1 million and the Target is $100,000, the price for the transferred assets should be $900,000.
In a Stock (Share/Interest) Sale: The buyer acquires the entire company—assets, liabilities, and all. Here, the goal is to ensure the company's balance sheet has the contractually agreed-upon Net Working Capital Target on the day of closing.
The most important rule is this: The working capital target must be defined in your initial offer, usually in the Letter of Intent (LOI).
If you wait until late-stage due diligence to bring this up, the seller holds all the cards. You've already spent thousands on legal and accounting fees and are emotionally invested in the deal. This "sunk cost fallacy" puts you in a weak negotiating position, often forcing you to accept an unfavorable working capital "peg."
In a share deal, your offer should clearly define Net Working Capital with a formula like this:
Net Working Capital = Cash + Accounts Receivable + Prepaid Expenses − Accounts Payable − Deferred Revenue
By setting a specific dollar target for this calculation in the offer, you establish a clear benchmark. If the actual Net Working Capital at closing is lower than the target, the purchase price is reduced dollar-for-dollar.
Due Diligence & Verifying the Numbers
Your financial due diligence must go beyond just looking at the profit and loss statement. You need to analyze the company's cash conversion cycle and ask questions like:
When does the company spend money on inventory and labor?
How long does it take to deliver the product or service?
How long does it take for customers to pay their invoices?
Building a two-year, month-by-month cash flow forecast can reveal if the business regularly dips "into the red" during certain months, signaling a shortage of operating capital. It will also show you the cash strain that can be caused by rapid growth—as sales increase, the investment required in AR and inventory also increases, which can paradoxically lead to a cash crisis.
As a general rule of thumb for small retail or cash-based businesses, a healthy Net Working Capital Target is often around 10% of annual operating expenses, or about five weeks' worth of expenses. However, every industry is different, and detailed analysis is required.
The Bottom Line
Your goal is to ensure that your total investment—the combination of your equity, your bank loan, any seller financing, and the working capital you must fund to meet the Target—does not exceed the Enterprise Value you determined was fair based on the business's cash flow.
Ignoring working capital is an invitation for financial distress. Before you sign any offer, consult with a CPA and an M&A attorney who are experienced in these transactions. They will know how to properly analyze, negotiate, and document a working capital provision that ensures you are buying not just a business, but a business with the fuel it needs to succeed from day one.
