Two parties can agree a purchase price and still be a long way apart on what they are buying. The working capital peg is where that gap shows. A buyer pays for a business that can run on the day after closing, with customers owing money and suppliers waiting to be paid in the normal way. The peg defines what normal means.
What a working capital peg does
Net working capital is, in most deals, current assets less current liabilities, with cash and debt left out because they are dealt with separately in the price. In a services business that is mainly receivables and work in progress less payables and accruals.
The peg is a target figure for that number. At closing the seller delivers the business with an estimate of actual working capital. After closing, usually within a set number of days, both sides calculate the real figure. If it comes in below the peg, the price falls. If it comes in above, it rises.
The point is fairness. Without a peg, a seller could collect every receivable and delay every payable in the final months, take the cash, and leave the buyer to fund the gap.
How the number is usually set
Most pegs start from an average of monthly working capital over a recent period, often the trailing twelve months. An average smooths out a single good or bad month and gives both sides something they can check.
Twelve months is not always right. A seasonal business has a working capital cycle that follows the calendar, so the peg should reflect the month you are closing in, not the year's average. A fast-growing business needs more working capital each month than the last, so an average of the past year understates what it needs now. In both cases a shorter or adjusted period is fairer.
A sharp change during diligence is a warning sign. If receivables are growing faster than revenue, customers are paying more slowly. A peg averaged over a period before that started will leave the buyer short.
Why the definition matters more than the number
Buyers spend time on the averaging period and too little on the definition underneath it. The definition decides what goes into each monthly figure.
Old receivables. An invoice six months overdue is in the ledger as an asset, but it may never be collected. Many buyers exclude receivables past a set age, or those from customers who have stopped paying.
Obsolete or slow inventory. Stock that will not sell is still on the balance sheet. Exclude it, or value it at what it will realise.
Accruals that are missing. A cash-basis business may have no accrued payroll, unbilled expenses or customer deposits on its books. Those liabilities still exist. If they are not in the peg calculation, working capital looks higher than it is.
Customer deposits and deferred revenue. Cash received for work not yet done is a liability. The buyer will have to do the work. Leave it out and the seller keeps the cash for work the buyer finishes.
Related-party balances. Amounts owed to or from the owner or the owner's other companies are usually settled at closing and kept out of working capital.
Agree these items line by line in the purchase agreement, with an illustrative calculation attached. A worked example removes most later arguments.
Getting the true-up right
The peg is only useful if someone can calculate the closing figure later. That needs clean cut-off at the closing date. Every invoice and every bill has to sit on the right side of the line, and work in progress has to be valued as at the closing date.
Plan for it to take time. The closing calculation often runs to several weeks of work, and the buyer is doing it while running a business they have owned for a month. We cover the mechanics in the 90-day working capital true-up.
What the peg will not protect you from
The peg covers working capital. It does not cover earnings that turn out lower than you were told, or liabilities that were not disclosed. Those are matters for the quality of earnings, the representations and warranties, and any escrow or indemnity in the agreement.
It also does not fix a working capital need that grows after closing. If you plan to grow, you will need more working capital than the peg delivers, and that has to be in your financing plan.
Frequently asked questions
What is a working capital peg?
A working capital peg is the level of net working capital the buyer and seller agree a business needs to operate normally. The seller delivers that amount at closing, and the purchase price is adjusted up or down for any difference.
How is a working capital peg calculated?
Usually as an average of monthly net working capital over a recent period, often the trailing twelve months, adjusted for seasonality and for items both parties agree to exclude, such as old receivables or related-party balances.
What is excluded from net working capital in an acquisition?
Cash and debt are normally excluded because they are handled separately in the price. Many deals also exclude receivables past a set age, obsolete inventory and balances with the owner or related parties.
What happens if working capital at closing is below the peg?
The purchase price is reduced by the shortfall. The adjustment is usually settled in the post-closing true-up, often against a seller note or an escrow.
Should the peg use a 12-month average?
Not always. Seasonal businesses should reflect the month of closing, and fast-growing ones need a shorter or adjusted period. If receivables are rising faster than revenue during diligence, a longer average will understate what the business needs.
Where CFOLogic fits
In buy-side diligence we rebuild monthly working capital on an accrual basis, test the definition line by line and model the peg against the closing month you are likely to hit. After closing, we prepare the true-up and keep the cut-off clean so the calculation can be done once.