Avoid Deal Killers: Estimating Working Capital Before You Go Under LOI
Chris Barrett
Introduction
One of the most common questions business buyers ask is, “How much working capital should I include in my deal?” It’s a critical concern—because if underestimated or miscalculated, working capital can derail even the most promising M&A transactions.
Understanding and forecasting working capital needs before signing a Letter of Intent (LOI) is essential to maintaining deal momentum and avoiding post-closing surprises. This article provides a clear, actionable way to estimate how much working capital your deal might require using the cash conversion cycle.
Understanding Working Capital in M&A
Working Capital is defined as current assets minus current liabilities. It represents the liquidity a business needs to operate on a day-to-day basis. For buyers, having an accurate estimate of working capital is key to ensuring that the acquired business continues running smoothly post-acquisition.
In M&A transactions, buyers use working capital to negotiate post-closing adjustments. Unfortunately, many buyers overlook this step and end up blindsided by unexpected shortfalls during final negotiations or after the deal closes.
Visualizing the Cash Conversion Cycle
To estimate working capital needs, it’s important to understand the cash conversion cycle (CCC)—a simple yet powerful financial concept that illustrates how long a company’s cash is tied up in operations.
Key Components:
Days Inventory Outstanding (DIO): Time inventory sits before being sold.
Days Sales Outstanding (DSO): Time it takes to collect payment after a sale.
Days Payable Outstanding (DPO): Time the business takes to pay its suppliers.
Formula:
CCC = DIO + DSO – DPO
A longer CCC means more cash is locked in operations, increasing the need for working capital. A shorter CCC indicates more efficient cash management.
Estimating Working Capital Needs Pre-LOI
Step-by-Step Guide
- Calculate Average Daily Sales
Divide the annual revenue by 365.
Example: $1,250,000 ÷ 365 = $3,425/day - Estimate the Cash Conversion Cycle Duration
Based on business operations, you might determine:- DPO = 30 days
- DIO = 60 days
- DSO = 30 days
- CCC = 60 days (DIO + DSO – DPO)
- Calculate Estimated Working Capital Requirement
Multiply average daily sales by the CCC duration.
Example: $3,425 × 60 = $205,500
This approach won’t give you a perfect number, but it’s a reliable way to get a ballpark figure before you go under LOI.
Importance of the Working Capital Peg in LOIs
The working capital peg is a target number agreed upon in the LOI or purchase agreement, usually based on historical working capital averages. It determines the baseline for post-closing adjustments.
Why It Matters:
- If actual working capital at closing is below the peg, the buyer may receive a purchase price reduction.
- If it’s above the peg, the seller could receive more money post-closing.
Negotiation Tips:
- Use a 12-month average to account for seasonal fluctuations.
- Clearly outline what’s included or excluded in working capital.
- Ensure both buyer and seller agree on the calculation methodology.
Best Practices for Buyers
To avoid working capital becoming a deal killer, follow these practices:
- Start Early: Begin estimating working capital during the initial deal analysis.
- Perform Diligence: Review accounts receivable, accounts payable, and inventory in depth.
- Hire Experts: Engage financial advisors or transaction experts to validate assumptions.
- Be Transparent: Clearly communicate working capital expectations with the seller.
Conclusion
Working capital can either stabilize your deal or sink it. Accurately estimating your working capital needs before signing an LOI helps you avoid surprises, negotiate confidently, and set a clear foundation for post-closing operations.
Using tools like the cash conversion cycle not only simplifies the process but also empowers you with financial clarity. When done right, it brings you one step closer to closing a successful, stress-free transaction.
Watch: How Much Working Capital Should I Include in My Deal?
Want a quick visual explanation? Watch this short video where I break down how to calculate working capital before signing a Letter of Intent (LOI).
Pre-LOI Net Working Capital Calculator
Avoid the number one cause of dead deals. This calculator will help you estimate Net Working Capital early so you can avoid big surprises later.
Frequently Asked Questions About Net Working Capital
Working capital reflects a company’s ability to meet short-term financial obligations. In M&A, it ensures smooth post-deal operations and affects purchase price adjustments.
A longer CCC means cash is tied up longer, increasing working capital needs. Shorter CCC improves liquidity and efficiency.
A peg is the target working capital level agreed upon in the LOI or purchase agreement, used to adjust the purchase price based on actual working capital at closing.
Absolutely. Misestimating working capital can lead to last-minute disputes and derail the entire transaction.
Start as early as possible—ideally before drafting your LOI—to negotiate effectively and prevent future misunderstandings.
Disclaimer
The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting, or investment advice. You should consult a qualified legal or tax professional regarding your specific situation.
