When a buyer submits an LOI, the whole conversation is about SDE and the multiple. Working capital gets a sentence, or nothing.
That is understandable. At LOI you usually have a CIM, maybe two years of P&Ls, and no detail. But working capital can move as much value as the multiple does, and the time to raise it is before the price is anchored, not after.
Current assets that come with the business minus current liabilities that come with it. In practice, for a small business, that is mostly accounts receivable, inventory, work in progress, prepaid expenses, accounts payable, accrued payroll, and deferred revenue.
The question a deal has to answer is simple to state: on the morning after closing, does the business have enough short-term assets to keep operating without the buyer writing another check?
Take a business doing $3 million in revenue that collects in about 60 days. That is roughly $500,000 sitting in receivables at any moment.
If the purchase agreement leaves AR with the company, the buyer takes over on day one with no cash coming in for two months while still making payroll, paying vendors, and now covering debt service. That is a real financing need on top of the purchase price, and it is not in most LOIs.
If the AR transfers, the buyer is effectively paying for it inside the purchase price. That can be perfectly reasonable, but it should be a decision rather than a surprise.
Neither treatment is wrong. What causes problems is when the parties never discussed it and discover the disagreement two weeks before closing.
These are the ones that catch construction, services, and anything with contracts.
Work in progress is work performed and not yet billed. It is an asset, and if a contractor is carrying $200,000 of it at closing, someone is going to finish the work and someone is going to collect on it. Those should be the same party.
Deferred revenue is the reverse: cash already collected for work not yet delivered. A pest control business with annual prepaid plans has a liability, not a windfall. The buyer inherits the obligation to perform without the cash that funds it.
Both of these also distort earnings on cash-basis books, which is a separate problem and one of the reasons we produce an accrual view rather than working only off the tax basis.
In larger deals this is formalized as a working capital target, or peg: a normal level of working capital, usually an average over the trailing twelve months, that the company must deliver at closing. If actual working capital at closing is above the peg, the buyer pays the difference. If it is below, the price comes down.
Small business deals often skip the peg entirely. Sometimes that is fine. But without one, there is nothing stopping a seller from collecting receivables aggressively and stretching payables in the last sixty days, which drains working capital right before the handover and is difficult to argue about after the fact.
You do not need a full analysis at LOI. You need to reserve the ground. One or two sentences is enough:
Purchase price assumes the business is delivered with a normal level of working capital, including accounts receivable and inventory, consistent with the trailing twelve month average. Working capital treatment to be confirmed in diligence.
That single sentence keeps the conversation open, signals to the broker that you know what you are doing, and stops you from having to reopen price later, which is where deals get emotional.
By the time you are drafting the purchase agreement, you should have:
Working capital is one of the most judgment-driven parts of a deal, which is exactly why it should be documented rather than assumed. Small changes in the assumption move real money, and the party who thought about it first usually ends up on the right side of it.