Working capital pegs

What a working capital peg is, and how it's typically set

Working capital, in this context, means cash, accounts receivable, and inventory, net of accounts payable — roughly, what the business needs on hand to keep running day to day without an emergency cash injection the moment new ownership takes over. The peg is the negotiated target amount of working capital the seller commits to leave in the business at closing.

Rather than picking an arbitrary number, the peg is typically set against a trailing average of the business's own historical working capital — commonly the trailing 12 months, sometimes adjusted for known seasonality if the business has a predictable busy or slow cycle. The logic: the business should be handed over with roughly what it normally carries to run itself, not artificially stripped down or padded right before the sale.

Setting the peg requires real financial data — monthly or at least quarterly balance sheet detail over the trailing period — which is itself a reason the peg negotiation and the seller-financials diligence work (see the seller financials guide) tend to happen around the same time.

The true-up mechanism: who pays whom, and when

The peg shows up in the purchase agreement as a true-up mechanism, not just a stated target. At closing, an estimate of the working capital actually delivered is used to close the deal; a short time later — commonly 60 to 90 days — final numbers are calculated and reconciled against the peg.

If the working capital actually delivered comes in above the peg, the buyer pays the seller the difference — the seller left more than agreed, so the buyer would otherwise have gotten extra assets for free. If it comes in below the peg, the seller pays the buyer — the seller let cash or receivables run down before handing over the business, so the buyer needs an offsetting payment to bring working capital back up to what was promised.

This mechanism protects both sides from opposite failure modes: a seller who'd otherwise have no reason not to let the business run down to bare bones right before close, since price is already agreed, and a buyer who might otherwise underpay for a business that's actually being handed over unusually cash-rich.

Common disputes: what counts, and disagreements over the baseline

What counts as working capital isn't always as obvious as it sounds. Disputes commonly arise over items like prepaid expenses (do they count as an asset in the calculation), a specific large receivable that's genuinely uncollectible (should it be excluded rather than counted at face value), or inventory that's obsolete or slow-moving (booked at full value versus a written-down value).

The historical baseline itself can also be contested. A business with real swings in working capital across the year — heavy seasonality, a large annual contract renewal — makes a single trailing-12-month average a much blunter instrument than it is for a steady, low-seasonality business, and either side may push for a baseline period that happens to favor their position.

Defining exactly what counts, and exactly what period the baseline is drawn from, in the LOI or an accompanying term sheet — rather than leaving both to be argued out during purchase agreement drafting — heads off a dispute that otherwise tends to surface right when both sides are trying to get to closing quickly.

Why this belongs in the LOI, not the purchase agreement

A working capital peg left out of the LOI entirely (see the LOI essentials guide) gets negotiated from scratch during purchase agreement drafting, with no anchor from the earlier agreement — and with real money already sunk into diligence and legal spend, pressuring both sides to just get it resolved quickly rather than get it resolved well.

Putting even a rough peg methodology in the LOI — a working capital target based on the trailing 12-month average, true-up within 90 days of closing — doesn't require having final numbers yet, but it does establish the mechanism and the general approach both sides have agreed to. That's exactly the kind of specificity that keeps this from becoming one of the negotiation sticking points that stalls a deal late (see the negotiation sticking points guide).