Key Takeaways
- The working capital peg sets the baseline for liquidity at closing: It helps reduce the risk of unexpected purchase price adjustments for both buyers and sellers.
- Defining Net Working Capital components upfront is critical: Inclusion and exclusion decisions directly impact deal value and potential disputes.
- Purchase price adjustments are tied to actual NWC at closing: They result in dollar-for-dollar increases or decreases relative to the peg.
- A well-supported peg requires historical analysis and normalization: It is both an important accounting exercise and a key negotiated deal term.
As any business enters the sales process or looks to acquire another business, the buyer and seller will go to great lengths to agree on a purchase price. However, once a deal has been struck, there is an additional nuance that can cause each party consternation and may require additional negotiation. That final piece is determining the working capital peg.
For many privately held business owners, the goal of a sale is to maximize cash at close and ensure a smooth transition. Yet, without a clear understanding of how liquidity is measured, you may find yourself leaving money on the table or facing unexpected purchase price reductions. The working capital peg is designed to prevent these surprises by establishing a "normal" level of operations to be delivered at closing.
Navigating this calculation requires a balance between accounting precision and deal strategy. Below, we address the working capital peg as it relates to a merger or acquisition, how to calculate it, and why it remains one of the most vital components of a successful M&A transaction.
What is Working Capital Peg?
Working capital generally represents a business’s current assets less its current liabilities. Examples of current assets used to determine a working capital peg are accounts receivable, inventory, and prepaid expenses, whereas examples of current liabilities are accounts payable, payroll-related liabilities, and other current accrued expenses.
The net amount between these two categories comprises a business’s working capital.
What is Included in Net Working Capital?
If you are looking for how to calculate a working capital peg, you must first define the specific components of Net Working Capital (NWC). Not every current asset or liability on your balance sheet belongs in this calculation.
What is included in a working capital peg typically covers the operational engines of the business:
- Accounts Receivable (AR): Money owed by customers for goods or services delivered.
- Inventory: Raw materials, work-in-progress, and finished goods.
- Accounts Payable (AP): Short-term obligations to suppliers.
- Accrued Expenses: Operational liabilities like utilities or office expenses.
Common Exclusions
To keep the peg focused on operations, several items are usually stripped out:
- Cash and Cash Equivalents: Most deals are "cash-free/debt-free."
- Debt: Short-term notes or lines of credit are handled separately.
- Taxes: Income tax assets/liabilities are usually excluded.
- One-time Accruals: Non-recurring items that don't reflect daily operations.
Working Capital Peg vs. Net Debt
It is easy to confuse these two adjustments, but they serve very different masters in the "Equity Bridge" (the calculation from Enterprise Value to the final check).
The working capital peg ensures the buyer receives enough operating liquidity to run the business on Day 1 without immediate cash infusions, while net debt adjusts the purchase price for financial obligations (loans, capital leases) and excess cash.
Why is Net Working Capital Important in M&A Transactions?
When a buyer and seller agree on the principal terms to transfer the ownership of a company, there is typically a period of one to three months between the agreement date and the actual closing date. The working capital peg ensures a reasonable amount of liquidity is transferred between parties as of that closing date.
From the buyer’s standpoint, an appropriate level of working capital must remain in the business. This eliminates the concern that a seller might "harvest" the business before handing over the keys — for example, by aggressively collecting all receivables or failing to replenish inventory in the weeks leading up to the close.
Conversely, the seller wants to ensure they aren't leaving "excess" money in the business. If collections are slow leading up to the close, the seller should be compensated for those high receivable levels, as they represent value created under the seller's ownership.
Common Negotiation Issues Between Buyers & Sellers in M&A Transactions
The working capital peg negotiation is often where the math meets the emotion of a deal. Each party has distinct priorities:
Buyers care about:
- Preventing WC depletion: Ensuring the seller doesn't stretch payables or stop buying inventory pre-close.
- Conservative definitions: Including "debt-like" items (e.g., aged payables or customer deposits) in NWC to lower the final price.
- Downside protection: Setting a peg high enough to ensure the business is "turn-key."
Sellers care about:
- Avoiding an inflated peg: An artificially high peg makes a price reduction more likely.
- Excluding debt-like items: Moving liabilities from the NWC calculation to the "Debt" line (which is often more favorable for the seller).
- Maximizing proceeds: Ensuring that "excess" working capital results in a dollar-for-dollar increase in the purchase price.
How the Working Capital Peg Impacts Purchase Price in an M&A Transaction
The peg acts as a price protection mechanism. Because the balance sheet of a company changes every single day, the peg provides a stationary target to measure against.
Working Capital Peg Example
Consider a deal where the parties agree to a Working Capital Peg of $10M.
Scenario A:
At closing, the actual NWC is found to be $12M. The buyer must pay the seller an additional $2M because the seller left more value in the business than expected.
Scenario B:
At closing, the actual NWC is only $8M. This results in a $2M purchase price reduction, as the buyer will need to inject their own cash to bring the business up to a normal operating level.
How Peg is Calculated: Step-by-Step
Determining the peg is more than a simple snapshot; it is a historical analysis. To arrive at a fair number, our advisors typically follow this 6-step process:
- Define NWC Components: Mutually agree on which GL accounts (AR, Inventory, AP, etc.) are in or out.
- Select a Historical Period: Most parties use a Trailing Twelve Month (TTM) or 18-month average to smooth out monthly fluctuations.
- Adjust for Seasonality: If a business peaks in December, a straight average might be misleading. Adjustments are made to ensure the peg reflects the time of year the deal closes.
- Normalize Anomalies: Strip out one-time spikes, such as a massive bulk inventory purchase or a pandemic-related supply chain disruption.
- Agree on the Peg: Both parties sign off on the final "target" number.
- Compare and Adjust: At closing (or shortly after), the "actual" NWC is compared to the peg, and a final cash adjustment is made.
Common Pitfalls & Disputes
Even with a clear formula, disputes often arise during the "true-up" period (typically 30–90 days post-close). Common issues include:
- Misclassified Items: Disagreements over whether an item is "Operational" (NWC) or "Financial" (Debt).
- Seasonality Errors: Failing to account for a business's natural cycles.
- Aggressive Management: Buyers claim the seller purposefully delayed paying vendors to boost cash.
Learn more about other pitfalls in earnouts and other capital provisions.
Securing Your Transaction with Help from Kreischer Miller
Navigating an M&A transaction can be stressful enough for privately held businesses. Having a third-party expert assist in evaluating financial data and developing the working capital peg can help streamline the process and support informed decision-making throughout the transaction.
If you would like to learn more about working capital in a deal and how it may apply to your business, please explore our M&A / Transaction Advisory Services and contact us.