The Working Capital Peg in M&A: How to Set It, Measure It and Avoid Disputes

Key takeaways

• Most purchase agreements assume the business will be delivered with a normal level of net working capital. The agreed target is the peg.
• If working capital at closing is below the peg, the price usually goes down; if it is above, the price goes up, often dollar for dollar.
• The peg is typically based on a normalized trailing average (often 12 months), adjusted for seasonality, growth and one-time items.
• Clear definitions of what is in and out of working capital prevent most post-closing disputes.

Sellers often focus on the headline price and multiple, and treat the working capital adjustment as fine print. That is a mistake. In many lower middle-market deals, the working capital adjustment moves the final price by hundreds of thousands of dollars, and it is one of the most common sources of post-closing disputes. Understanding how the peg works, and negotiating it carefully, protects value on both sides of the table.

Why deals include a working capital adjustment

A buyer paying a multiple of EBITDA expects to receive a business that can operate normally from day one, with enough receivables, inventory and payables to support that EBITDA. Without a working capital mechanism, a seller could, in theory, collect receivables aggressively, run down inventory or delay paying suppliers before closing, pocketing cash that the buyer will have to replace.

The adjustment ensures the price reflects the working capital actually delivered, compared with an agreed normal level.

What counts as net working capital?

The purchase agreement defines it, and the definition matters. A typical definition in a cash-free, debt-free deal:

Included (current assets):

• Accounts receivable, net of a reasonable allowance
• Inventory, net of obsolescence reserves
• Prepaid expenses that benefit the buyer

Included (current liabilities):

• Accounts payable
• Accrued expenses (wages, utilities, rent)

Usually excluded:

• Cash (the seller keeps it in a cash-free deal)
• Debt and interest-bearing liabilities (paid off at closing)
• Income tax assets and liabilities
• Transaction costs
• Debt-like items, which are often deducted from price separately rather than included in working capital, such as accrued but unpaid bonuses, deferred revenue on services not yet performed, customer deposits, deferred rent, and unpaid capital expenditure commitments

How debt and debt-like items reduce what sellers receive is covered in enterprise value vs. equity value.

How the peg is calculated

The most common starting point is the average of monthly net working capital over the trailing 12 months, using the same definitions as the purchase agreement. Analysts then adjust for:

• Seasonality. A landscaping or retail business may have very different working capital in spring than in fall. A 12-month average smooths this; in some cases a month-specific peg is more accurate.
• Growth. A fast-growing business needs more working capital over time. A peg based on an older average may be too low.
• One-time items. A large, unusual receivable or a bulk inventory purchase should be normalized out.
• Accounting consistency. Reserves and accruals must be calculated the same way in the peg and at closing.

Worked example

Trailing 12-month net working capital (in $ millions):

The 12-month average is about $2.13 million. After removing a one-time 80, 000receivablefromanunusualproject, thepartiesagreeapegof * *2.05 million**.

At closing, actual net working capital is 1.85million * * .Thepurchasepriceisreducedby * *200,000. If it had been $2.25 million, the seller would have received an extra $200,000.

Special situations

Seasonal businesses

When working capital swings sharply through the year, a flat 12-month average can favor one party depending on the closing month. Options include a month-specific peg (the expected level for the closing month based on prior years), or adjusting the closing date. Model several closing months before signing the letter of intent.

Fast-growing businesses

A company growing 25% a year needs more receivables and inventory every month. A trailing average understates what the business will need at closing. Buyers may argue for a peg based on the most recent three to six months; sellers may push back if growth is temporary. Agree the logic early.

Construction and project-based companies

Contractors carry contract assets and liabilities (costs and estimated earnings in excess of billings, and billings in excess of costs). Over-billing brings cash in early and creates an obligation to finish the work; buyers often treat net over-billings as debt-like rather than working capital. Work-in-progress schedules must be reviewed carefully.

Businesses with negative working capital

Subscription, membership and some service businesses collect cash before delivering the service, so working capital is negative. The peg can still work, but deferred revenue and customer deposits need especially clear definitions to avoid double counting with debt-like items.

Mechanics: estimate, true-up and disputes

• Estimated closing statement. A few days before closing, the seller estimates closing working capital, and the price paid at closing is adjusted using the estimate.
• Post-closing true-up. Within an agreed period, often 60 to 120 days, the buyer prepares a final closing statement.
• Review and objection. The seller has a set period to review and object.
• Dispute resolution. Unresolved items usually go to an independent accounting firm acting as an expert, whose decision is binding on the disputed items.

Some agreements include:

• A collar or de minimis threshold: no adjustment unless the difference exceeds an agreed amount.
• An escrow or holdback to secure any downward adjustment.

Common sources of disputes

• Vague definitions (“consistent with past practice” when past practice was inconsistent).
• Changes in reserves for bad debts or obsolete inventory between the peg period and closing.
• Cut-off errors in revenue, payables and accruals around the closing date.
• Debt-like items treated as working capital in one calculation and as debt in another, leading to double counting.
• Seasonal timing: closing at a low point in the cycle against an annual average peg.

Where a dispute turns into litigation or arbitration, independent analysis and testimony become essential. See our litigation support services.

Tips for sellers

• Commission a sell-side quality of earnings analysis that includes working capital, so you set the peg discussion on your terms. See quality of earnings vs. business valuation.
• Propose a specific definition and an illustrative calculation as an exhibit to the letter of intent.
• Avoid unusual actions before closing, such as aggressive collections or stockpiling inventory, that distort the comparison.
• Plan your closing date with seasonality in mind.
• Read our pre-sale valuation roadmap.

Tips for buyers

• Test the seller’s working capital history as part of due diligence, including proof of cash and aging of receivables and inventory.
• Make sure the peg supports the business’s growth plan, not just its past.
• Agree in advance how reserves will be calculated at closing.
• Plan post-closing liquidity. Even with a fair peg, seasonal swings may require a revolving facility; DebtRemediationTools.org compares options in business line of credit vs. term loan.

For a broader overview of the deal process, see DebtRemediationTools.org’s guide to buying or selling a business. The peg also interacts with how the price is allocated for tax purposes; see asset sale vs. stock sale.

Frequently asked questions

Next step

Negotiating a letter of intent or reviewing a closing statement? Contact Foxboro Consulting Group for working capital analysis, due diligence and transaction services.

This article is for general information and is not legal or accounting advice. Deal terms vary; work with experienced M*&*A counsel and accountants.

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