The Working Capital Peg: What Owners Lose at the Closing Table

Owners routinely sign a Letter of Intent (LOI) for $20 million and walk out of closing with $19.4 million. The missing $600,000 is almost never fraud and almost never something the attorney flagged. It is the working capital peg doing exactly what the purchase agreement said it would do. The peg is a standard Mergers and Acquisitions (M&A) mechanic that reconciles the business the buyer thought they were buying against the business the buyer actually received on the closing date. Across the lower middle market, owners who did not prepare for the peg lose $200,000 to $2 million at close. The ones who prepared, often with a Certified Exit Planning Advisor (CEPA®), lose little or nothing. The difference is not negotiating skill at the closing table. It is twenty-four months of operating discipline that happened before the LOI existed. This piece walks through what the peg is, how buyers set it, how it eats deals, the four levers worth negotiating, and the exit-planning move that solves most of the problem before the first offer arrives.

What Net Working Capital (NWC) actually is

Net Working Capital (NWC) is the operating cash the business needs to keep running from one Tuesday to the next. Current operating assets minus current operating liabilities. In owner language, it is the gap between what the business is owed and what the business owes, excluding the long-term stuff.

Think about a Tuesday afternoon in the business. There is a $5 bill in the register drawer. There is an invoice in a folder because the customer promised to pay in 30 days. There is a stack of paper in the supply closet that got bought last Tuesday from a vendor whose bill arrived this morning and has not been paid yet. There is a check in a drawer from a customer who paid six months early for a job that has not shipped. All of that, netted together, is working capital.

The accountant version lines up like this:

Current operating assets: Accounts Receivable (AR), inventory, prepaid expenses.

Current operating liabilities: Accounts Payable (AP), accrued expenses (payroll earned but not paid, taxes owed but not sent), deferred revenue or customer deposits.

NWC equals the first list minus the second. In almost every purchase agreement, cash is excluded (the owner keeps it) and interest-bearing debt is excluded (settled separately, dollar for dollar). What is left is the operating engine.

The peg exists because NWC changes every day. The business the buyer modeled, with $4.8 million of average working capital over the trailing twelve months, is not the same business the buyer receives on a Thursday morning in October when AR has turned over and inventory is low because the shop just shipped a big order. If the buyer paid the headline price and inherited a thinner operating balance, they paid too much. The peg is how both sides meet in the middle: the seller delivers an agreed amount of working capital at close, and if the delivered amount is short, the shortfall comes out of the price dollar for dollar.

Owners who hear "peg" for the first time at the LOI stage often assume it is a technicality. It is not. It is often the single largest line item that moves money after the headline is set.

How buyers set the peg

The question of what the peg should be is a negotiation that looks like an equation. The buyer's advisors present a method, cite it as standard, and build the number into the purchase agreement. There are at least seven variations. On the same business, different methods can produce peg targets that differ by hundreds of thousands of dollars.

Trailing Twelve Months (TTM) average. The buyer takes the monthly ending NWC balance for each of the last twelve months, averages them, and calls that the peg. This is the default in roughly half of mid-market deals. It is defensible because it treats a full annual cycle as the base. It is also owner-unfriendly for seasonal businesses closing in a trough month, because the delivered balance can sit well below the twelve-month average through no fault of operating performance.

Last Twelve Months (LTM) excluding spike months. The buyer argues one or two months in the base period are anomalies, usually containing customer prepayments, an inventory build, or a one-time Accounts Receivable (AR) surge, then excludes them and averages the rest. Excluding spike months almost always moves the peg higher, which raises the delivered-at-close requirement, which transfers value from seller to buyer. Sometimes the exclusion is reasonable. Often it is a selective reading of history.

Three-month trailing average. The buyer takes the three months immediately preceding close and averages them. Common in deals where the business has grown materially and the TTM would understate the current operating base. For a growing business this can favor the owner. For a declining business it does the opposite.

Forward-looking budget. The buyer sets the peg based on the twelve months projected after close, usually prepared during diligence. The most hostile method, because the owner is asked to deliver, on day one, a working capital balance sized for a future revenue level not yet produced. Common with Private Equity (PE) buyers modeling aggressive growth.

The remaining three variations (custom negotiated, blended average, and formula-based pegs tied to trailing revenue) are less common but worth naming. The point is to recognize, when the draft agreement arrives, which method the buyer chose and why. On a $20 million deal, the delta between owner-friendly and owner-unfriendly methods is routinely $300,000 to $800,000 of final price.

When the peg eats the deal

Five situations consistently produce the worst peg outcomes. These are patterns that show up in a meaningful share of lower middle market closings, with owners who had no idea the exposure existed until the preliminary closing statement arrived.

Seasonality mismatches. A food and beverage distributor closes in late January, after holiday returns and before spring buying. TTM NWC averaged $4.8 million. The delivered balance is $4.1 million because that is what the cycle looks like in late January. The buyer deducts $700,000. The business did nothing wrong. The owner closed in the wrong month under a flat-average peg.

Inventory pile-ups mid-cycle. A manufacturer with a large customer order has built inventory for shipment the week after close. Inventory sits $800,000 above trailing average. Under a flat-average peg this helps the owner. If the agreement excludes "non-recurring inventory events" without careful language, the buyer argues the surge is non-recurring and recomputes the delivered balance net of it, costing the owner the swing.

AR write-downs during the sale process. The sale runs eight months. A $400,000 receivable at 90 days aging is still unpaid. The buyer's Quality of Earnings (QoE) review flags it as uncollectible and insists it be written off before close. That $400,000 comes out of delivered NWC and deducts from price. The receivable may still get paid later, but by then the owner has lost it.

Prepaid customer deposits treated as debt-like. A services business collects 50% up front. Deposits sit on the balance sheet as a current liability under deferred revenue. The buyer's advisors argue the deposits are debt-like, cash held for work not yet performed. By reclassifying, the buyer removes a liability from the peg (raising the target) and simultaneously deducts the deposit balance from the price as debt. The owner is hit twice on the same number if this is not negotiated explicitly.

Intra-month timing of the close. Nothing stops a closing on the 14th rather than the 30th. If the AR cycle turns at month-end and the business ships on the 15th, closing on the 14th means delivered inventory is high and delivered AR is low. The mismatch between base-period definition and close-date snapshot can swing hundreds of thousands.

None of these are hostile acts. They are the ordinary mechanics of a document drafted to protect the buyer's underwriting. The owner's job is to see them coming before the LOI is signed.

The four negotiation levers

Once a draft purchase agreement is on the table, four levers determine how much of the peg risk the owner carries. Each one deserves real negotiating attention. None of them should be left to the buyer's first draft.

Base-period selection. The single most valuable lever. The method used to compute the peg (TTM, LTM excluding spikes, three-month trailing, forward-looking budget, or custom) drives the peg number. Owners should prepare their own analysis of delivered NWC under at least three methods well before the LOI, so they can propose the method that best reflects the real operating business. Seasonal business, propose a seasonality-adjusted base. Growing business, propose a recent-period base. The buyer's method is a starting point, not a given. Owners who concede the base period lose the most leverage they will ever have on the peg.

Excluded items. Working capital events that are genuinely non-recurring should be excluded from both the base-period and the delivered-at-close calculation, symmetrically. Items worth negotiating in explicit language: one-time inventory builds for known orders, prepaid customer deposits (exclude from both sides or include in both sides, never a mismatch), unusual AR surges from a single customer prepayment, and any working capital movement caused by payment-term changes imposed during diligence. Each exclusion needs to be named, with "non-recurring" defined in writing. Soft language like "customary adjustments" is the owner's enemy.

True-up window length. After close, the buyer computes actual delivered NWC and compares it to the peg. The window for that calculation is called the true-up window. 60 to 90 days is standard. 120 is acceptable. 180 is seller-unfriendly, giving the buyer six months of operating control to generate ammunition for an adjustment. Owners should also negotiate the window to review and dispute the buyer's calculation, at least 30 days after delivery.

Dispute mechanism. If the parties disagree on the post-close NWC calculation, the escalation path matters. The standard is an independent accounting firm, pre-named in the agreement, whose determination is binding. Second best is binding arbitration with a defined scope and timeline. Worst is litigation-only, which gives the buyer a cost advantage because the owner has limited funds left to fight once the price has already been reduced. Insist on independent accountant, specified firm or short list, binding, inside a 60-day window. Written in advance, this clause often never gets used, because the buyer knows the owner has clean recourse.

The four levers compound. An owner who negotiates all four well on a $20 million deal can shift $400,000 to $1 million of risk back toward the buyer. An owner who negotiates none of them is at the mercy of the first draft.

A worked example

A $20 million deal. A specialty distributor with roughly $35 million of revenue, $4 million of Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), and seasonal AR and inventory swings. The buyer, a lower middle market PE firm, proposes a TTM-average peg of $4.8 million. The owner, who had not modeled the peg before signing the LOI, accepts the method.

Scheduled close is February 15. In the twelve months preceding close, monthly NWC averaged $4.8 million, with a seasonal high of $5.4 million in September (ahead of fourth-quarter shipments) and a seasonal low of $4.1 million in late January and February. The peg sits at the twelve-month flat average, $4.8 million.

On the February 15 closing date, delivered NWC is $4.3 million:

• AR: $3.3 million (seasonal low, customers paid down over the holidays)
• Inventory: $2.4 million (seasonal low, pre-restock)
• Prepaid expenses: $0.2 million
• AP: ($1.3 million)
• Accrued expenses: ($0.3 million)
• Customer deposits: $0 (the buyer successfully reclassified them as debt-like during diligence)

The $4.3 million delivered against a $4.8 million peg produces a $500,000 shortfall, deducted dollar for dollar. The owner closes at $19.5 million, not $20 million. Separately, the buyer deducts $100,000 for customer prepaid deposits classified as debt-like, a reclassification negotiated into the LOI without the owner understanding its effect. Total hit: $600,000.

What could the owner have done differently? Four things.

Negotiated a seasonality-adjusted peg. A peg comparing February to prior February would have produced a peg closer to $4.3 million. No shortfall.

Run an AR collection push in the 60 days before close. Accelerating $300,000 of AR would have moved delivered NWC to $4.6 million, cutting the shortfall by more than half.

Negotiated customer deposits as a current liability inside the peg. Would have avoided the $100,000 double hit.

Modeled the peg before the LOI. The composite of the three moves above was worth $600,000. Running the model takes a spreadsheet and a willing CFO. It does require starting at least 90 days before the LOI.

These numbers are illustrative composites. Real deals vary. The mechanics do not.

How exit planning in advance solves the peg problem

The peg problem is almost entirely a preparation problem. Exit planning is not the transaction. Exit planning is the ongoing set of business practices, run twenty-four months to five years before any sale, that make the business worth more and give the owner real options when the right time to sell arrives.

An owner who runs an exit planning discipline, often with a CEPA®, does four things that neutralize the peg:

Clean AR. Aging receivables get worked down over twenty-four months, not during the panicked month before close. Writing off bad debt in advance means delivered NWC is clean when the QoE team arrives.

Right-size inventory. Inventory discipline means the balance on the shelves is operating inventory, not accumulated slow-moving stock. The peg conversation becomes a conversation about real working capital.

Know the NWC run rate twenty-four months out. The owner who can produce a monthly NWC chart going back twenty-four months, with seasonality visible, enters the LOI negotiation with the strongest possible position. They are proposing the peg method, not reacting to the buyer's.

Model the peg before the LOI. Run three or four variations of the peg method against your own historical data before signing. The negotiation becomes informed, not reactive.

The owners who lose the least to the peg are not the ones with the best negotiators at the closing table. They are the ones whose businesses, long before any transaction, were run with the operating discipline that makes the peg a reconciliation rather than a surprise. That is the exit planning move. Not the transaction. The practices that preceded it.

Frequently Asked Questions

What is a working capital peg in a business sale?

A working capital peg is the agreed amount of operating working capital, Accounts Receivable (AR) plus inventory plus prepaid expenses minus Accounts Payable (AP) minus accrued liabilities, the seller must deliver at closing. It is written into the purchase agreement. If delivered working capital falls short, the shortfall comes out of the purchase price dollar for dollar. If delivered amount exceeds the peg, the seller gets the excess.

Why do buyers set a working capital peg at all?

Buyers underwrite the deal on a business that generates a certain operating balance. If the business is delivered with less working capital than modeled, the buyer has to inject cash to keep operations running, meaning they effectively overpaid. The peg protects the buyer from that. It is a standard mechanic, but the method and the number are both negotiable.

Can the peg actually change the price I receive?

Yes, routinely, often by more than owners expect. The peg can move final price by $200,000 to $2 million on a typical lower middle market deal. The variation is driven by the base-period method, the treatment of items like customer deposits, and the timing of the close relative to the business's seasonal cycle.

What is the difference between a working capital peg and an earn-out?

An earn-out is contingent purchase price paid after closing, tied to future performance over 12 to 36 months. A working capital peg is a reconciliation at or shortly after closing, tied to the balance sheet delivered on the closing date. Earn-outs reward or penalize what happens after the sale. The peg reconciles what the business looks like at the moment of the sale.

How long does the true-up window typically last?

Standard is 60 to 90 days after closing, during which the buyer finalizes the delivered working capital calculation. The seller then has a defined window, typically 30 days, to review and dispute. Longer windows (120 to 180 days) favor the buyer and should be pushed back on. Dispute mechanisms should name an independent accounting firm as binding arbiter.

Should I hire a Quality of Earnings (QoE) team before the sale starts?

Many owners find a sell-side QoE review valuable, in part because it stress-tests the working capital methodology before the buyer's team arrives. A sell-side QoE identifies which receivables may be contested, which inventory is slow-moving, and how deposits should be classified. On deals above $10 million of enterprise value, it is worth evaluating.