The working capital peg is the agreed amount of net working capital that has to be in the business on the day it changes hands. Fall short of it and the purchase price gets reduced dollar for dollar. Exceed it and the seller is generally paid the difference. It is one of the least discussed terms in a letter of intent and one of the most expensive to get wrong.
Owners tend to focus on the headline number and the multiple. The peg is where a meaningful amount of that headline number can quietly disappear between signing and settlement.
Why buyers insist on it
A buyer paying for a business is paying for an operating company, not an empty shell. The company needs receivables to collect, inventory to sell, and a normal level of payables outstanding. If it arrives without those, the buyer has to fund them immediately, which effectively raises the price they paid.
Absent a peg, a seller has an obvious incentive in the final months: collect receivables hard, stretch payables, run inventory down, and take the cash out. The business still looks the same on the income statement while the balance sheet has been drained. The peg removes that incentive by defining what normal looks like and settling the difference in cash.
This is why most deals are structured on a cash-free, debt-free basis. The seller keeps the cash and pays off the debt at closing, and the peg governs everything in between.
How the peg gets set
The mechanics are straightforward. The negotiation is not.
The peg is typically calculated as an average of monthly net working capital over a trailing period, most often the twelve months preceding closing. Both parties, usually working from the quality of earnings analysis, build a schedule of monthly balances and agree on a target.
Three variables drive the outcome, and each is negotiable:
VariableWhy it matters
Averaging period
A trailing twelve-month average smooths seasonality. A shorter period can skew the peg high or low depending on where the business sits in its cycle at the time.
Included accounts
Which balance sheet items count as working capital. Deferred revenue, accrued bonuses, and related-party balances are common points of contention.
Accounting methodology
The peg and the closing calculation must use identical methodology. Where they differ, disputes generally follow.
The seasonality trap
For businesses with pronounced seasonality, timing can matter as much as the negotiation. Consider a construction or paving company whose receivables peak in late summer and trough in winter. A trailing twelve-month average produces a peg somewhere in the middle of that range.
If closing lands at the seasonal peak, actual working capital may sit well above the average, and the seller is generally owed the excess. If closing lands at the trough, actual working capital may be well below the peg, and the purchase price is reduced accordingly, even though nothing about the business has changed.
This is a mechanical outcome, not a negotiating failure, but it can be planned for. Sellers in seasonal industries benefit from modeling the peg against likely closing dates early, rather than discovering the effect during the final weeks of a process.
How cash-free, debt-free actually works
The peg only makes sense alongside the convention that surrounds it. Most private company deals are quoted on a cash-free, debt-free basis, which describes what the enterprise value actually buys.
Under that convention the seller keeps the cash in the bank at closing, the seller pays off interest-bearing debt out of the proceeds, and the buyer receives the operating assets and liabilities of the business, sized to the peg. Enterprise value is the agreed price for the business itself. What the seller actually receives is that figure plus cash, minus debt, plus or minus the working capital adjustment, minus transaction expenses.
The step that catches sellers out is the definition of debt. Buyers frequently argue that items beyond the bank facility should be treated as debt-like and deducted from proceeds. Common candidates include capital lease obligations, accrued but unpaid bonuses, deferred compensation, unfunded pension or benefit liabilities, accrued but unpaid taxes, customer deposits, and deferred revenue on prepaid work.
Each of those is negotiable, and each moves money. An item classified as debt-like reduces proceeds directly. The same item treated as a working capital component instead only matters to the extent it differs from the peg. Sellers benefit from settling this list explicitly rather than leaving it to the definitions section of a draft purchase agreement.
A worked example
Consider a business where the parties set the peg at the trailing twelve-month average of net working capital, and the definition includes accounts receivable, inventory, prepaid expenses, accounts payable, and accrued liabilities, while excluding cash and debt.
If actual net working capital at closing comes in below that agreed target, the purchase price is reduced by the shortfall, dollar for dollar. If it comes in above, the seller is generally paid the excess. There is no multiple applied to the difference. This is a balance sheet settlement, not a valuation adjustment, which is why the peg is often described as the least glamorous and most literal term in the agreement.
The practical implication is that operating decisions in the final months before closing have a direct, uncushioned effect on proceeds. Drawing inventory down to generate cash does not increase what the seller receives, because the cash benefit is offset by a working capital shortfall. Understanding that early tends to prevent well-intentioned but self-defeating decisions during the run-up to a closing.
Where sellers most often lose money
A handful of issues account for most of the value that leaks out of this term.
- Agreeing to the peg before understanding it. Letters of intent sometimes specify a peg amount or a methodology before the seller has modeled what it means. Once it is in an executed letter of intent, renegotiating is difficult.
- Loose definitions. If the agreement says "net working capital determined in accordance with GAAP applied consistently" without a worked schedule attached, both sides are relying on interpretation. Attach an actual example calculation.
- Deferred revenue. For companies with prepaid contracts or service agreements, whether deferred revenue counts as a working capital liability can move the settlement significantly.
- Aged receivables. Buyers often push to exclude receivables past a certain age, or to reserve against them. A seller with a slow-paying customer base can lose real value here.
- No dispute mechanism. Without a defined process and a named independent accountant, a disagreement can drag on with the seller's money sitting in escrow.
How the true-up actually settles
The sequence is usually as follows. At closing, the parties estimate working capital and adjust the price against the peg using that estimate. Then, within a defined window that commonly runs 60 to 90 days, the buyer prepares a closing statement showing actual working capital as of the closing date.
The seller gets a review period, typically 30 to 45 days, with access to the records used to prepare the statement. If the seller disputes items, the parties negotiate. Anything unresolved goes to an independent accounting firm, which rules only on the disputed items. That determination is generally binding on both parties.
Because a portion of the purchase price is often held in escrow specifically to fund a potential shortfall, this process determines when the seller actually receives the last of the proceeds.
How to prepare
The preparation that helps most starts well before a process launches.
- Produce accurate monthly balance sheets. The peg is built from monthly data. If the monthly closes are unreliable, the seller has no basis to argue for a favorable target.
- Clean up receivables and inventory in advance. Writing off genuinely uncollectible receivables and obsolete inventory before the measurement period generally produces a lower, more achievable peg than carrying them and having the buyer reserve against them later.
- Model the peg against plausible closing dates. Particularly in seasonal businesses, this can change how the timeline is negotiated.
- Negotiate the methodology, not just the number. A favorable target with an unfavorable definition is not a favorable outcome.
- Attach a sample calculation to the purchase agreement. This single step prevents a large share of disputes.
The working capital peg rewards preparation more than negotiation. Owners who have clean monthly financials and have modeled the mechanics tend to arrive at settlement with far fewer surprises than those who address it in the final weeks of a deal. If you are working through an offer and want to understand what the terms mean for your net proceeds, we are available for a confidential discussion.
