A working capital peg is the level of net working capital, receivables and inventory less payables and accrued expenses, that the seller must leave in the business at closing. It is usually the trailing twelve-month average of normalized monthly balances. At closing the price moves up or down by the gap between the peg and what is actually delivered, and a final true-up follows. A peg set too low lets the seller keep working capital the business needs, and the buyer refills it by drawing the revolver on day one, using capacity the lender sized for something else.
- What it measures
- Operating current assets less operating current liabilities; cash and debt left out
- How it is usually set
- Trailing twelve-month average of normalized month-end balances
- What the true-up does
- Moves the price for any gap between the peg and working capital delivered
- Who feels a low peg
- The buyer's revolver, from the first draw after closing
- What the lender watches
- Availability on the line at closing, and leverage including any day-one draw
The peg is part of the price, not an accounting footnote
Most businesses in the lower middle market sell on a cash-free, debt-free basis: the buyer pays for the operating business, the seller keeps the cash and pays off the debt. What that leaves undecided is how much money has to be tied up in the business for it to keep running: customer invoices not yet collected, stock on the shelves, prepaid expenses, less what is owed to suppliers and employees. That net figure is working capital, and it moves every month.
A seller who controls the business until closing controls that figure too. Collect receivables hard, stop buying inventory, let supplier bills age, and the seller's bank account fills up at the business's expense. The peg stops that. It fixes the amount the buyer is entitled to receive, and any shortfall comes off the price. It is the part of the price that decides whether the company arrives able to operate.
The transaction side of the peg, how it is written into the letter of intent and the purchase agreement, is covered on how a working capital peg affects acquisition financing. This page is about the other side of it: what the peg does to the debt structure a lender has already agreed to.
How the peg is set
The usual method has three steps. First, define net working capital account by account, so that the same balances are measured the same way every month. Second, normalize each month: write off receivables that will never be collected, reserve for stock that will never sell, book the accruals a small company often records only at year-end, and remove anything that was a one-off. Third, average the twelve normalized month-ends before closing. The result is the peg.
| Balance | Usually in the peg | Lender's reason to care |
|---|---|---|
| Trade receivables, net of bad debt | Yes | They are the collateral behind the revolver |
| Inventory, net of obsolete stock | Yes | Advance rates run off net orderly liquidation value, not cost |
| Prepaid expenses | Yes | Small, but no collateral value |
| Trade payables and accrued expenses | Yes, as a deduction | Stretched payables must be paid back to terms after closing |
| Cash | No | Kept by the seller in a cash-free deal |
| Bank debt, shareholder loans, capital leases | No, treated as debt | Paid off at closing or counted as funded debt |
| Customer deposits and deferred revenue | Argued over | Work the buyer must perform with cash the seller has already received |
| Income taxes payable | Usually excluded, handled as a pre-closing tax item | An unpaid tax bill left behind is a claim on the buyer's cash |
The twelve-month average exists because working capital swings through the year. A landscaper's receivables peak in late summer; a distributor builds inventory before its selling season. An average smooths those swings so neither side can pick a convenient month. In a growing business, last year's average understates what next year needs. In a seasonal one, the month of closing matters as much as the average: a deal that closes just before the busy season needs working capital heading toward its high point, not its mean.
Normalization is where most of the money is. A seller's monthly balance sheets rarely carry proper accruals, and receivables that are months overdue sit in the total at full value. A quality of earnings report usually rebuilds net working capital month by month on a consistent basis. That schedule is often the first time anyone sees what the business actually needs to operate.
How the true-up adjusts the price
Just before closing, the seller estimates the working capital it will deliver. The price paid at closing is adjusted for the gap between that estimate and the peg. Later, within a period the purchase agreement sets, the buyer prepares the actual closing balance sheet and the price is adjusted again for the gap between the estimate and the actual figure. Agreements often add a small band within which no adjustment is made, a cap on how far the price can move, and an escrow or holdback so a refund owed to the buyer has a source.
Take a peg of 2,000. The seller estimates 1,850 at closing, so the price paid falls by 150. The final balance sheet shows 1,780, so the seller owes a further 70, which comes out of the adjustment escrow. What the true-up cannot do is compensate for a peg that was wrong to begin with.
The true-up protects the buyer up to the peg and not a dollar beyond it. If the peg is too low, the seller delivers exactly what was agreed and owes nothing.
What a low peg does to the revolver
A lender financing an acquisition often builds the debt in two parts. A term loan, or an SBA 7(a) loan, funds the purchase price. A revolving line of credit sits beside it to carry the business through seasonal swings, a slow-paying customer or a large order. The lender sizes that line on the assumption that the business arrives with a normal level of working capital and the line largely undrawn. Term debt and a line do different jobs, and the peg is what keeps them separate.
Now suppose the business really needs 2,000 of net working capital to run, but the peg was set at 1,600 off months when the seller had stretched its suppliers. The seller delivers 1,600 and owes nothing back. In the weeks after closing, the buyer has to bring suppliers back to terms and carry receivables at their normal level. That 400 has to come from somewhere, and in almost every deal it comes from the line of credit.
| Peg matches what the business needs | Peg set 400 too low | |
|---|---|---|
| Net working capital delivered at closing | 2,000 | 1,600 |
| Revolver commitment | 1,500 | 1,500 |
| Borrowing base availability at closing | 1,200 | 1,200 |
| Drawn in the first weeks to restore working capital | 0 | 400 |
| Availability left for the first season | 1,200 | 800 |
| Senior debt counted by the lender (term loan of 3,000 plus revolver drawn) | 3,000 | 3,400 |
| Senior leverage on EBITDA of 1,200 | 2.5 times | about 2.8 times |
Three things have happened in the right-hand column, and none of them shows up in the purchase agreement. The buyer has a third less room on the line going into its first busy season. Its senior leverage is higher than the lender's model, because a drawn revolver counts as funded debt the moment it is drawn. And the interest on that draw is a new cost in debt service coverage that no one budgeted. If the credit agreement sets a leverage covenant on the model's figures, covenant headroom has shrunk before the first quarter is tested.
The asset-based version of the same problem
On an asset-based line the damage can be worse, because the peg and the borrowing base measure different things. The peg counts receivables at book value. The borrowing base counts only eligible receivables, and receivables more than 90 days past invoice are typically ineligible. Asset-based lenders typically advance 80% to 90% of eligible receivables, and borrowing bases commonly cap any single customer at 20% to 25% of eligible receivables.
A seller can hit the peg on paper by collecting its best invoices before closing and leaving old ones in the total. Net working capital looks normal. Eligible receivables, and therefore availability, are much lower than the lender expected. The same happens with inventory: inventory typically advances at up to 85% of net orderly liquidation value, or roughly half of cost, so slow-moving stock that counts in full toward the peg adds very little to the line. A buyer on an asset-based structure should test the peg against an AR aging by customer and an inventory report as of the closing month, not just against the balance sheet total. See excess availability for how lenders measure the room that is left.
How lenders protect themselves, and what they will ask you
Lenders have learned to look for a low peg because it shows up later as a request for more money. The protections they use are practical:
- A minimum availability condition at closing. Many revolving lenders require a stated amount of undrawn availability after all closing payments are made. A shortfall in working capital eats into it directly.
- Diligence on the peg itself. The lender reads the monthly working capital schedule, the AR and AP agings and the purchase agreement's definition, and asks why the peg differs from the average if it does.
- Working capital in the sources and uses. Where the business will need cash at closing, the lender would rather see it funded explicitly, from equity or a term loan line in the sources and uses, than discover it in the first borrowing base certificate.
- On an SBA loan, working capital inside the loan. A 7(a) loan can finance working capital as part of the project, with maturities up to 10 years for working capital and goodwill. A peg that leaves the business short changes how much of that the buyer needs.
How much working capital to fund at closing, and from which source, is covered in how much working capital to finance when buying a business.
Negotiating a peg the debt can live with
- Agree the method before the number. An account-level definition and a trailing twelve-month average of normalized balances in the letter of intent prevents most later disputes.
- Compare the peg with the month you close in. If closing falls near a seasonal peak, the average understates what the business needs that week.
- Check payables against terms. Payables stretched beyond normal terms before a sale make working capital look lower than it is; a peg built on those months is too low.
- Run the peg through the borrowing base. Ask what availability the line would have at closing if the business arrives exactly at the peg.
- Fund the adjustment escrow. A refund owed to the buyer that has to be chased from the seller is a refund that may not arrive while the line is being drawn.
A financing model built for lenders should show the peg, the working capital the business actually needs and the revolver availability at closing side by side, so the gap is argued with the seller rather than discovered by the lender. That is how Transparent lays out the lender package. For the terms themselves, the glossary entry on the working capital peg is a short reference.
Common questions
- Is the working capital peg the same as the working capital I need to fund at closing?
- No. The peg is what the seller must deliver. What you fund at closing is anything the business needs beyond that, such as a larger peak season or a growth plan. If the peg is set correctly, the second number is small.
- Does cash count toward the peg?
- Usually not. In a cash-free, debt-free deal the seller keeps the cash and the peg measures operating working capital only. Some agreements require a minimum operating cash balance to be left in the business, which is negotiated separately.
- Who calculates the peg?
- Usually the buyer's side proposes it, often from the monthly working capital schedule in a quality of earnings report, and the seller negotiates. Both sides should work from the same account-level definition.
- Why would a lender care about a clause between buyer and seller?
- Because a peg set too low is paid for with the lender's revolver. A drawn line counts as funded debt, raises leverage above the lender's model and leaves less availability for the season the line was sized for.
- What if the business is growing quickly?
- A trailing average will understate what the business needs next year. Buyers often argue for a peg weighted to recent months, or plan to fund the growth in working capital explicitly at closing.