Key takeaways
- Most middle-market deals are priced on a cash-free, debt-free basis with a “normal” level of working capital delivered at closing.
- The working capital peg (or target) is the agreed normal level. If actual working capital at closing is above the peg, the seller is typically paid more; if below, the price goes down, often dollar for dollar.
- How working capital is defined, and how the peg is calculated, are negotiated points that can be worth hundreds of thousands of dollars.
- Seasonality, growth, accounting inconsistencies and one-time items are the most common sources of disputes.
- Sellers should analyze working capital before signing a letter of intent, not after.
A business owner agrees to sell for $10 million. The letter of intent is signed, diligence goes smoothly, and closing day arrives. Then the seller learns that the price will be reduced by $340,000 because working capital came in “below the peg.”
The seller remembers agreeing to a peg, but not to giving up a third of a million dollars.
The net working capital (NWC) adjustment is one of the least understood and most consequential mechanisms in a business sale. This article explains why it exists, how it is calculated, and how to protect yourself.
Why the working capital adjustment exists
When a buyer agrees to a purchase price based on a multiple of EBITDA, it assumes the business will come with enough working capital to operate normally the day after closing: receivables to collect, inventory to sell, and payables at normal levels.
Without an adjustment, a seller could, in theory, collect receivables aggressively, run down inventory and delay paying vendors in the months before closing, converting working capital into cash and pocketing it. The buyer would then have to inject cash just to keep the business running.
The working capital mechanism prevents this by:
- setting a target (the peg) representing a normal level of working capital; and
- adjusting the purchase price up or down for the difference between the target and the actual working capital delivered at closing.
It is closely related to the cash-free, debt-free convention discussed in our article on EBITDA multiples.
What counts as working capital?
In accounting terms, working capital is current assets minus current liabilities. In M&A, the definition is negotiated and usually narrower.
Typically included: – accounts receivable (net of an appropriate allowance); – inventory (net of reserves for obsolete or slow-moving items); – prepaid expenses that will benefit the buyer; – accounts payable; – accrued expenses (wages, payroll taxes, utilities, etc.); and – deferred revenue or customer deposits (sometimes treated separately as debt-like).
Typically excluded: – cash (because the deal is cash-free); – interest-bearing debt and the current portion of long-term debt (because the deal is debt-free); – income taxes payable or receivable (often handled separately); – transaction expenses; and – items the seller retains, such as related-party receivables.
The purchase agreement should define working capital precisely, often with an illustrative calculation attached as an exhibit showing exactly which general ledger accounts are included.
How the peg is set
The most common approach is to calculate the average normalized working capital over a recent period, often the trailing twelve months, using month-end balances.
Example
A distribution company’s month-end net working capital (excluding cash and debt) over the last twelve months:
| Month | NWC |
|---|---|
| Nov | $1,650,000 |
| Dec | $1,700,000 |
| Jan | $1,750,000 |
| Feb | $1,800,000 |
| Mar | $1,850,000 |
| Apr | $1,900,000 |
| May | $1,950,000 |
| Jun | $1,900,000 |
| Jul | $1,850,000 |
| Aug | $1,800,000 |
| Sep | $1,750,000 |
| Oct | $1,700,000 |
| Average | $1,800,000 |
The parties agree to a peg of $1,800,000.
At closing
| Scenario A | Scenario B | |
|---|---|---|
| Peg | $1,800,000 | $1,800,000 |
| Closing NWC | $1,600,000 | $1,950,000 |
| Adjustment | ($200,000) price reduction | +$150,000 price increase |
In Scenario A, the seller receives $200,000 less. In Scenario B, the seller receives $150,000 more.
Where the money is: common negotiation points
1. Seasonality
If the business is seasonal, an average may not reflect what is needed at the time of closing. A landscaping company that closes in April, when receivables and inventory are building, may deliver working capital far above a twelve-month average, and should be compensated. Conversely, closing at a seasonal low could trigger a large price reduction. Some deals use a monthly peg or adjust the target for the expected closing month.
2. Growth
In a growing business, working capital rises with sales. A trailing average understates what is needed today. Buyers may argue for a higher peg based on recent months; sellers may argue that growth should be funded by the buyer going forward. Both positions should be grounded in the data.
3. Normalization
The working capital used for the peg should be normalized in the same way EBITDA is: – remove one-time items, such as an unusual inventory build for a single large order; – correct accounting errors and inconsistent cutoffs; and – apply consistent reserves for bad debts and inventory.
A quality of earnings analysis usually includes a working capital analysis for exactly this reason.
4. Accounting policies
If month-end balances were prepared on a cash or modified basis while closing working capital is prepared under GAAP, the comparison is apples to oranges. The agreement should specify that closing working capital will be calculated using the same accounting principles, practices and methodologies used to set the peg.
5. Debt-like items
Items such as deferred revenue, customer deposits, accrued bonuses, deferred rent and unpaid prior-year taxes are often argued to be debt (reducing price dollar for dollar) rather than working capital. Each classification has a real cost to someone, and the same item should not be counted twice.
6. Collars and de minimis thresholds
Some agreements include a collar (no adjustment unless the difference exceeds a threshold) or a de minimis amount, to avoid arguing over small variances.
The closing process and true-up
Most deals follow a two-step process:
- Estimated closing statement. Shortly before closing, the seller prepares an estimate of closing working capital, and the price paid at closing is adjusted based on the estimate.
- Post-closing true-up. Within a set period, often 60 to 120 days, the buyer prepares a final closing statement. The seller reviews it and can dispute items within a specified time. If the parties cannot agree, disputes typically go to an independent accountant whose decision is binding on the disputed items.
A portion of the purchase price is sometimes placed in an adjustment escrow to secure payment of any downward adjustment.
How sellers can protect themselves
- Analyze working capital early, ideally a year or more before a sale, to understand normal levels, seasonality and trends. Our pre-transaction valuation roadmap covers this preparation.
- Address the peg methodology in the letter of intent. “Normal level of working capital” is too vague. Agree on the approach early, while leverage is balanced.
- Clean up the balance sheet. Write off uncollectible receivables and obsolete inventory before the measurement period, and reconcile accounts monthly.
- Insist on a detailed definition and an illustrative calculation exhibit.
- Watch for double counting between working capital and debt-like items.
- Manage the business normally before closing. Don’t accelerate collections or delay payables; the true-up usually captures it.
- Use advisors who understand both valuation and transaction accounting.
How buyers can protect themselves
- Test whether historical working capital supports the business plan.
- Scrutinize reserves for receivables and inventory.
- Identify unrecorded liabilities that may surface after closing.
- Negotiate an appropriate escrow for adjustments and indemnification.
- Review cutoff procedures around the closing date.
Our financial due diligence checklist covers these points.
Frequently asked questions
No. The peg is a target for the purchase price adjustment. A holdback or escrow is money set aside to secure payment of adjustments or indemnification claims.
In a typical cash-free, debt-free deal, yes. Cash is excluded from working capital and generally belongs to the seller, subject to any minimum cash requirement negotiated by the buyer.
Typically, the buyer pays the seller the difference, subject to any collar or cap in the agreement.
Most agreements designate an independent accounting firm to resolve disputed items.
Yes. In an asset sale versus a stock sale, the specific assets and liabilities transferred, and therefore the working capital definition, can differ.
The bottom line
The working capital peg is a technical mechanism with a very practical effect: it can increase or decrease the cash you receive at closing by six or even seven figures. Understanding your normal working capital, and negotiating the definition and methodology early, is one of the most valuable things a seller can do.
Foxboro Consulting Group, Inc. provides transaction services, working capital analysis and due diligence support for buyers and sellers. Contact us to discuss your transaction.
This article is for general informational purposes and does not constitute legal, tax, accounting or investment advice. Purchase agreement terms should be reviewed with qualified M&A counsel and advisors.
