The working capital peg: the silent haircut at closing
The owner negotiated a $20 million purchase price for 18 months. The wire on closing day was $11.04 million. Everything in between is correct, normal, and disclosed somewhere in the purchase agreement. The single biggest line item the owner did not expect was a $1.2 million working capital adjustment. The buyer was not unfair. The deal lawyer was not asleep. The owner just did not understand how the working capital peg worked, and by the time it mattered, the leverage was gone.
Almost every middle-market sale contains a working capital adjustment. Almost every owner is surprised by how much it can move the final number. The mechanism is not exotic. It is one of the most established conventions in M&A, and the rules are predictable. But the rules favor the side that understood them before the LOI was signed, and that is almost never the seller.
What working capital means in a deal context
Net working capital, in plain terms, is the cash a business needs in its bloodstream to operate. Inventory the business has bought but not yet sold. Customer invoices the business has issued but not yet collected. Bills the business has received but not yet paid. The arithmetic is simple: current operating assets minus current operating liabilities.
When a buyer acquires a business, they want it delivered with enough working capital in the bloodstream to keep operating without an emergency cash injection on day one. Not too little, or the buyer has to write a check the day after closing to keep payroll running. Not too much, or the seller is leaving usable cash on the table.
The agreement standardizes the right amount by setting a peg. The peg is a target dollar number, typically based on the trailing 12 months of the business's actual working capital, averaged. On closing day, the buyer measures actual working capital against the peg. If actual is above the peg, the buyer pays the seller the difference on top of the headline price. If actual is below the peg, the buyer subtracts the difference from what they wire. The peg makes the working capital delivered with the business neutral to both sides, so the headline price reflects the business's earnings power and not its cash position on a particular day.
What goes into the calculation, and what stays out
The single most important paragraph in any working capital schedule is the one defining which balance sheet items count and which do not. The same headline business can produce wildly different peg numbers depending on the definitions.
Three of those line items, in particular, are where money is made or lost in the peg negotiation: deferred revenue, accrued expenses, and inventory reserves. A reasonable advisor can move the peg by hundreds of thousands of dollars by negotiating the definition of each one before signature, and not afterward.
How the peg is set
The methodology of setting the peg is almost always one of these three.
Trailing 12-month average
The most common approach. The buyer pulls the seller's monthly balance sheets for the trailing twelve months, computes NWC at the end of each month under the agreed definition, averages the twelve numbers, and proposes that average as the peg.
This method is reasonable for a stable business with consistent seasonality. It is brutal for a growing business, because rapid growth pushes recent months higher than older months and the average understates the working capital the business genuinely requires. It can also be brutal for a seasonal business if the LOI happens to be signed at a peak or trough.
Trailing 12-month average, seasonally adjusted
A more careful approach takes the trailing 12-month average and adjusts it for the seasonal position of the closing month. A peg targeting a December closing date should reflect what working capital normally looks like in December, not the calendar-year average. Sellers with seasonal businesses should push for this method aggressively. Buyers often resist it because it adds calculation complexity, but the case is strong.
Most recent quarter
The buyer proposes the most recent quarter as representative. This method favors the buyer in nearly every situation: if the business has grown, the recent quarter is higher than the trailing 12 months, so the peg is higher and the seller has more to deliver. Sellers should resist this method unless their business is shrinking, in which case it works in their favor.
How the peg is settled, and the second adjustment
The peg gets enforced in two passes.
At closing. The seller delivers an estimated closing balance sheet a few days before closing. The buyer reviews it and the parties agree on an estimated NWC number at the closing date. If estimated NWC is below the peg, the buyer wires the headline price minus the difference. If above, the buyer wires the headline price plus the difference. This is the number the seller actually sees in their account on closing day.
The true-up, usually 60 to 90 days later. The buyer's accountants prepare a final closing balance sheet with all the period-end adjustments that take weeks to settle. They compare the final NWC against the peg. If the final number is materially different from the estimated number used at closing, a cash true-up flows in whichever direction. If actual was higher than estimated, the buyer wires the seller the difference. If actual was lower, the seller has to write a check back to the buyer.
The true-up is where the second wave of unpleasant surprises lands. The seller has already deployed the cash from closing; collecting the true-up if it goes the seller's way is straightforward. Writing a six-figure check back to the buyer 75 days after closing is a different conversation.
Where sellers lose money they did not have to lose
The recurring mistakes are not subtle. They are the same handful, repeated.
Sweeping cash before closing
Owners want their last working-capital cash in their pocket, not the buyer's. So they sweep all available cash from the business in the days before close. The instinct is correct. The execution is usually wrong, because the cash they swept was funding the working capital cycle: paying vendors so AP stays normal, prepaying rent and insurance so prepaids stay normal, funding payroll so accrued wages stay normal.
Sweep the cash, and the AP balance balloons (because nothing was paid), the prepaids drop, accrued wages spike. Each one of those moves NWC further below the peg. The buyer wires less at closing, and the seller has effectively converted a controlled withdrawal into an uncontrolled one.
Slowing collections in the pre-close period
The opposite mistake. Owners learn that AR is a NWC asset and stop pushing for collections, on the theory that more AR equals more peg. This works only if the higher AR is real and collectable; if it is just aged AR sitting on the books, the buyer will reserve against it in the true-up and reduce the final NWC. The seller gets nothing for the higher gross balance, and may have damaged customer relationships along the way.
Deferred revenue treatment
Deferred revenue is cash the business has collected for goods or services not yet delivered. From an accounting standpoint, it is a liability. From a buyer standpoint, it is also an obligation that comes with the business: the buyer has to deliver the goods or services post-closing without receiving any cash for them, because the seller already got the cash.
Buyers therefore push to include deferred revenue in NWC (as a liability), which lowers the peg and forces the seller to leave more current assets in the business to compensate. Sellers push to treat deferred revenue as a debt-like item, settled separately, or to exclude it from the calculation entirely. On businesses with meaningful deferred revenue (SaaS, prepaid services, maintenance contracts), this single line item can be worth seven figures of disputed value. It should be settled before the LOI, in writing.
Inventory and AR reserve methodology
The agreement should specify the methodology for reserves (aging buckets, specific identification, percentage formulas) in concrete terms. Vague language ("calculated in accordance with the company's historical accounting practices") gives the buyer the right to argue, after closing, that the seller's historical practice was too lax. Specific language locks in the methodology and removes most of the dispute surface.
The single biggest one: not modeling the peg before the LOI
Most sellers never model their own NWC against a likely peg until the buyer's first draft of the purchase agreement lands. By then, the LOI is signed and the seller's leverage is gone. A modest investment in pre-LOI NWC modeling, run by a competent transaction advisor, would have given the seller a defensible peg number to negotiate, instead of accepting the buyer's number under deadline pressure.
A worked example of the haircut
Two versions of the same deal. Same business, same headline price, same closing date. The only difference is whether the seller prepared for the working capital adjustment.
Same business, same headline price, prepared seller. The peg was pre-negotiated, the deferred-revenue treatment was settled, the inventory reserves were defined, and the closing was scheduled for a month with naturally higher working capital. No NWC shortfall. The cash wire is $12,240,000. The prepared seller netted $1.2 million more for the same business sold at the same price.
That difference is not theoretical, and it is not negotiation gimmickry. It is the difference between an owner who showed up to the closing table aware of how the peg worked and an owner who did not.
The five questions to settle before signing the LOI
- What methodology is being used to set the peg? Trailing 12-month average, seasonally adjusted average, most recent quarter, or something else. Each one produces a meaningfully different number for the same business.
- Which line items are in NWC and which are out? Deferred revenue, accrued bonuses, tax accruals, intercompany balances. Get the list on paper, not in conversation.
- What reserve methodology will be used for inventory and AR? Specific aging buckets, specific percentage formulas, specific obsolescence policies. Vague language is the buyer's tool.
- How and when does the true-up settle? 60-day or 90-day window, neutral accountant for disputes, dollar threshold below which no adjustment is made.
- What is my actual NWC for the trailing 12 months, modeled under the buyer's expected definition? If you cannot answer this question two months before the LOI, you are not ready to negotiate the LOI.
Working capital is the part of the deal where ordinary spreadsheet work, done early, is worth more than aggressive negotiation done late. The math is not hard. The conventions are knowable. The leverage to apply them lives almost entirely in the window before the LOI is signed.
Sources: American Bar Association Mergers & Acquisitions Committee, Private Target M&A Deal Points Study (2023 and 2024 editions). SRS Acquiom, 2024 M&A Deal Terms Study. RSM US, Net Working Capital in M&A Transactions (March 2024). BDO, Quality of Earnings and Working Capital Considerations (October 2025). Internal Revenue Code Section 1060 (for asset-deal allocation context). Examples and commentary are the work of the Next Chapter Wealth editorial team and are general in nature. Specific transactions require analysis by qualified deal counsel and transaction accountants.