A working capital peg is the normal level of net working capital (receivables and inventory, less payables and accrued expenses) that the seller agrees to deliver with the business at closing. It is usually set from a trailing average of monthly balances, adjusted for one-offs. After closing, the actual figure is measured and the price moves up or down by the difference. A peg set too low leaves the buyer funding a working capital hole the day after closing, which the lender sees as a liquidity problem the purchase price was supposed to cover.
- What it measures
- Receivables and inventory, less payables and accrued expenses
- Usually set from
- A trailing average of normalized monthly balances
- Excluded in a cash-free, debt-free deal
- Cash, funded debt, income taxes, deal costs
- Settled by
- A post-closing true-up that moves the price
- The lender's concern
- Whether the business is handed over able to run without new borrowing
Why a purchase price needs a peg
A buyer who agrees a price for a business on a multiple of its earnings is paying for a business that can produce those earnings. That business needs a certain amount of money tied up in receivables and inventory, net of what it owes suppliers, to operate normally. The price assumes that money comes with the company. Most lower-middle-market deals are priced cash-free and debt-free: the seller keeps the cash and pays off the debt. Without a peg, nothing stops the seller from also collecting every receivable, running inventory down and stretching payables in the weeks before closing, and taking that cash home too.
The peg closes that gap. It is a number in the purchase agreement, often first stated in the letter of intent, for the net working capital the business must hold at closing. If the business is delivered with less, the seller gives back the difference. If it is delivered with more, the buyer pays for the extra. The term is defined on its own in the glossary; this page is about what it does to the loan.
How the peg is set
The starting point is net working capital measured the same way at the end of each of the last twelve months, then averaged. Averaging matters because working capital moves: a contractor's receivables swell with its busiest season, a distributor's inventory builds ahead of a selling period. A single month-end, especially one the seller chooses, can be the lowest point of the year. Before averaging, each month is normalized: owner loans, income tax accruals, items that belong to the seller, and one-off balances are taken out so the figure reflects the business as the buyer will run it.
| Usually included | Usually excluded | Often argued over |
|---|---|---|
| Trade receivables, net of doubtful accounts | Cash and cash equivalents | Customer deposits and deferred revenue |
| Inventory, net of obsolete stock | Funded debt, including shareholder loans | Accrued bonuses and commissions |
| Prepaid expenses | Income tax balances | Receivables well past their due date |
| Trade payables | Transaction costs of the sale | Accrued vacation and other payroll items |
| Accrued operating expenses | Amounts owed to or by the seller personally | Inventory reserves and write-downs |
A trailing average is a convention, not a law. When the business is growing, last year's average understates what next year needs, and buyers argue for a peg weighted to recent months. When sales are falling, sellers argue the reverse. A quality of earnings report usually includes a month-by-month working capital schedule, and on deals that have one it is where both sides start.
How the true-up works
At closing, the seller delivers an estimate of net working capital and the price is adjusted for any difference from the peg. After closing, within a period the purchase agreement fixes, the buyer prepares the actual closing balance sheet. The price is adjusted again for any difference between the estimate and the actual figure. Disputes go to an independent accountant named in the agreement. Many agreements ignore small differences inside an agreed band, so that neither side argues over rounding.
| Step | Figure | Effect on price |
|---|---|---|
| Peg in the purchase agreement | 600 | |
| Seller's estimate delivered at closing | 560 | Price cut by 40 at closing |
| Actual figure on the final closing balance sheet | 540 | Seller pays back a further 20 |
| If the actual figure had come in at 630 | 630 | Buyer pays the seller 70 more than the closing price |
Where the seller owes money back, the cleanest source is an escrow or holdback set aside at closing, or an offset against a seller note. Chasing a seller for a refund after they have been paid is slower and less certain. How escrows and holdbacks sit beside the lender is covered in escrow and holdback in acquisition financing.
When the peg is too low: the lender's view
The true-up only protects the buyer up to the peg. If the peg itself is set below what the business needs, the seller can deliver exactly the agreed figure, owe nothing back, and still hand over a business that is short of cash to operate. Take a seasonal business whose normalized net working capital averaged 600 over the last year and peaked at 700. The seller proposes a peg of 480, the balance at its year-end low point, and the buyer agrees without checking the months in between.
On the day after closing, the business needs roughly 600 to run at its normal pace and has 480. As the busy season arrives, it needs 700. The buyer has to find 120 at once and 220 at the peak, and the only place to find it is borrowing: a draw on the line of credit, or a request to add working capital to the term loan. The buyer has now paid for that working capital twice, once in a price that assumed it was there, and again with debt.
A peg set too low does not show up at closing. It shows up in the first busy season, as a line of credit that is already drawn.
A lender reads this as a liquidity problem, and it is. The revolver was sized for seasonal swings, not to replace working capital that left with the seller. A buyer who starts with the line half drawn has less room for a slow-paying customer or a hard month, and less headroom under any covenant tied to it. The loan was also sized on a sources and uses that assumed the business came with its normal working capital. A late request to add working capital to the loan to fill a hole the seller created prompts the obvious question from credit: why did the price not cover it?
There is a second trap on asset-based lines. A seller can meet a peg on paper with receivables that are old and hard to collect, while collecting the good ones before closing. Receivables more than 90 days past invoice are typically ineligible for a borrowing base, so the business can arrive with the right net working capital and much less borrowing availability than the buyer expected. The definition of receivables in the peg should exclude what the lender will exclude.
What buyers should settle before the lender does
- Put a method in the letter of intent, not just a number. A trailing twelve-month average of normalized net working capital, with the included and excluded accounts named, prevents most later arguments.
- Check the peg against the months, not the average alone. The peak month tells you how much of the line of credit the business will use in its first season.
- Match the receivables definition to the lender's. Aged, disputed and related-party receivables should count at the value a lender would give them.
- Give the true-up a source of money. An escrow, a holdback or a right to offset against a seller note.
- Show the lender the peg. A lender that sees the working capital schedule and the peg together can size the line of credit for the business as it will actually be delivered.
How much working capital to fund at closing, and whether it goes in the term loan, a revolver or the buyer's cash, is a separate decision covered in working capital at close. How a peg cuts into debt capacity across the whole capital structure is on the working capital peg and debt capacity. Transparent's financing model carries the monthly working capital schedule and the peg side by side, so a lender sees the first season's borrowing need before it approves the line. What the model shows is on the package.
Common questions
- Is the working capital peg in the letter of intent binding?
- Usually not. The LOI's business terms are normally non-binding, but a peg or a method stated there is very hard to move later. The binding peg is the one in the purchase agreement.
- Does cash count toward the peg?
- Not in a cash-free, debt-free deal, which is the common structure. The seller keeps the cash, so the peg measures receivables, inventory and prepaid items, less payables and accruals.
- Who prepares the closing working capital figure?
- The seller estimates it at closing. The buyer, who now runs the books, usually prepares the final figure within a period set by the purchase agreement, and the seller can dispute it.
- Can the acquisition loan fund a working capital shortfall?
- Lenders can include working capital in an acquisition loan, and SBA 7(a) loans can fund it. What a lender will question is a shortfall created by a peg set below what the business needs, because that is value the buyer paid for and did not receive.
- What if the business is seasonal?
- Average the full year of month-end balances rather than one month, and check the peak month separately. A seasonal business's line of credit has to carry the peak, and a peg set near the low point leaves the line drawn before the season starts.