A working capital peg is the amount of net working capital, usually receivables, inventory and prepaid expenses less payables and accrued expenses, that the purchase price assumes the business will have at closing. Buyer and seller set it from the business's normal monthly levels. If the business is delivered with more than the peg, the buyer pays more; with less, the price comes down. An estimate adjusts the price at closing and a final true-up follows. Lenders care because a business handed over light on working capital must be refilled with borrowed money.
- What it measures
- Net working capital delivered at closing, excluding cash and debt
- Usual basis
- Average of normalized month-end balances over a trailing period
- Price effect
- Price rises or falls by the difference from the peg
- Timing
- Estimate at closing, final true-up after closing
- Lender's concern
- A light delivery gets refilled with the line of credit or loan proceeds
Why the price needs a peg
Most private businesses are sold cash-free, debt-free: the seller keeps the cash and pays off the debt. What the buyer gets is the operating business, and an operating business cannot run without receivables coming in, inventory on the shelves and suppliers being paid on normal terms. The price, usually a multiple of earnings, assumes all of that arrives with it.
Left unchecked, a seller could collect every receivable, run inventory down and stretch suppliers in the weeks before closing, keep the resulting cash, and hand over a business that needs an immediate injection to function. A seller could equally be shortchanged by an unusually heavy month. The peg removes the incentive both ways. It fixes the level of working capital the price includes, and the price moves by whatever the business actually delivers above or below it.
The peg is part of the price. A peg set too low is a price increase the buyer did not negotiate.
What counts as working capital
The definition in the purchase agreement matters as much as the number. The usual line items, and the ones that are argued over:
| Line item | Usually included? | Notes |
|---|---|---|
| Accounts receivable | Yes, net of an allowance for bad debts | Old or disputed receivables are often excluded or reserved |
| Inventory | Yes | At cost, less obsolete and slow-moving stock |
| Prepaid expenses | Yes | Insurance, rent and deposits that benefit the buyer after closing |
| Accounts payable | Yes, as a deduction | Trade payables on normal terms |
| Accrued expenses | Yes, as a deduction | Wages, payroll taxes, utilities and rent earned but not yet paid |
| Cash | No | The seller keeps it in a cash-free deal |
| Debt and accrued interest | No | Paid off at closing from the price |
| Customer deposits and deferred revenue | Negotiated | The buyer does the work the seller was paid for, so buyers argue these are debt-like |
| Income taxes payable | Usually no | Normally the seller's liability for periods before closing |
| Amounts owed by or to the owners | Usually no | Settled or excluded at closing |
Just as important is the accounting method. The agreement should require that closing working capital be measured with the same policies used to calculate the peg. A peg built on accrual figures and a closing balance built on the seller's cash-basis books will never agree. See accrual vs cash basis.
How the number is set
The starting point is usually the average of month-end net working capital over the trailing twelve months, after removing one-off items: an unusual bulk purchase of inventory, a large receivable later written off, an accrual booked only at year end. A quality of earnings report normally produces this analysis, month by month.
Two kinds of business need more than an average. A seasonal business may close in a month when working capital is naturally high or low, and an annual average then produces an adjustment that has nothing to do with the seller's conduct. The parties either use a peg for the closing month or compare against the same month in prior years. A growing business needs more working capital each month than the last, so a trailing average understates what it will need at closing; buyers argue for a peg weighted to recent months.
The method belongs in the letter of intent, even if the number is set later in the purchase agreement. A buyer who agrees the price in the LOI and leaves working capital for later has given away the leverage to argue about it.
How the true-up works
The adjustment happens twice. Shortly before closing, the seller estimates closing working capital and the price paid at closing is adjusted by the estimate's difference from the peg. After closing, once the books for the closing date are complete, the buyer usually prepares the final figure and the difference between estimate and final is settled. In plain numbers:
| Step | Net working capital | Effect on price |
|---|---|---|
| Peg agreed in the purchase agreement | 500 | Built into the headline price |
| Seller's estimate at closing | 460 | Price paid at closing reduced by 40 |
| Final figure after closing | 440 | Seller pays back a further 20; final price ends 60 below the headline |
| Alternative: final figure of 530 | 530 | Buyer pays the seller 70 after closing (the 40 deducted at closing, plus 30); final price ends 30 above the headline |
- Collars. Some agreements make no adjustment for small differences, within an agreed band either side of the peg, to avoid arguments over trivial amounts.
- Adjustment escrow. Part of the price is often held back to pay any amount owed to the buyer, separately from the indemnity escrow. See indemnity escrow and holdback.
- Disputes. The seller has a period to object to the buyer's final figure. Unresolved items go to an independent accountant whose decision is final.
Why lenders care
A lender financing the acquisition is lending against a business that must pay its suppliers and payroll from the first week. If the business arrives light, the buyer fills the gap with money borrowed for something else: the revolving line, or loan proceeds that were meant as a cushion. The purchase price adjustment may give some of that back later, but the cash is needed now.
- Asset-based lines. The borrowing base is built from receivables and inventory. Asset-based lenders typically advance 80% to 90% of eligible receivables, and receivables more than 90 days past invoice are typically ineligible. A seller who has collected hard before closing leaves fewer receivables, less availability, and a line that is drawn on day one.
- SBA and term loans. Working capital can be financed as part of an SBA 7(a) acquisition loan, with a term of up to 10 years. The lender sizes that piece on what the business will need, which assumes the peg delivers a normal level. See how much working capital to finance at close.
- An upward true-up. If the final figure is above the peg, the buyer owes the seller money after the loan has closed. Lenders ask where it will come from.
Lenders therefore read the peg analysis, the definition and the true-up mechanics alongside the purchase agreement. The working capital peg in acquisition financing and what a low peg does to the revolver go further into the lender's side. Transparent's financing model carries the peg, the expected closing figure and the effect on day-one liquidity and line availability, so the lender sees the business as it will actually be handed over.
Common questions
- Is working capital included in the purchase price?
- Yes. The price assumes a normal level of working capital, the peg, is delivered with the business. The true-up moves the price if the actual level is higher or lower.
- How does the peg relate to cash-free, debt-free?
- They work together. Cash and debt are excluded from working capital because they are dealt with separately: the seller keeps the cash and pays off the debt. The peg covers everything else the business needs to operate.
- Who sets the peg?
- The buyer and seller negotiate it, usually from a month-by-month analysis in a quality of earnings report. The method should be agreed in the letter of intent.
- What if we cannot agree the final working capital figure?
- Most purchase agreements send disputed items to an independent accountant, whose decision binds both sides.
- Does SBA set a working capital peg?
- No. The peg is a term between buyer and seller. SBA lenders review it because it affects how much working capital the loan needs to include and whether the business can service its debt from the start.