The working capital peg

Anchored to
The most common late-stage price adjustment

Why the mechanism exists

A buyer agrees a price for a business on the assumption it comes with the working capital it needs to keep operating: enough receivables, enough inventory, and payables in their usual state. Without a mechanism, a seller could collect every receivable, sell down inventory, stretch every payable, and hand over a company that needs an immediate cash injection to trade on Monday. The buyer would have paid the agreed price for materially less.

The peg exists to stop that, in both directions. It is not a trap. It becomes a fight because it is usually introduced late and because the definition of normal is genuinely arguable.

How it works

The parties agree a target, the peg, expressed as a level of working capital, typically current assets less current liabilities with cash and debt excluded because those are dealt with separately. At closing an estimate is struck and the price is adjusted against the target. Some weeks later the actual figure is calculated from closing accounts and a true-up payment moves in whichever direction the difference points.

Two features do the work. The definition decides what counts, and the target decides how much of it there has to be. Sellers focus on the target and lose on the definition.

The argument about normal

The target is usually set from an average of recent months. Every element of that is negotiable and each choice moves money.

How many months are averaged, and which. A business with seasonal inventory has a very different working capital need in different quarters, and averaging a period that includes the build but not the sell-down sets a target the seller has to fund. Whether the average is of month-ends or of a trailing measure. Whether a recent change in collection practice counts as the new normal or an anomaly. Whether slow-moving inventory is included at cost, at a written-down value, or excluded.

None of these is dishonest. They are judgement calls, and the party that has thought about them beforehand wins most of them.

Where sellers get caught

The recurring ones are worth naming. Deferred revenue treated as a current liability, so that customer money already collected for work not yet done reduces the price. Accrued holiday and bonus entitlements landing in the calculation for the first time at closing. Inventory the seller has always carried at cost being written down by a buyer applying a different obsolescence policy. Receivables past a certain age excluded entirely rather than reserved. And a target set on a period the seller did not realise was unusually strong.

The other trap is timing. The true-up is often the last money to move, months after closing, when the seller has no leverage left and the buyer controls the accounting records the calculation depends on. A dispute resolution clause naming an independent accountant and a short timetable is worth insisting on while it is still cheap to ask.

What to do about it

Raise it early. The peg belongs in the letter of intent, at least in principle, alongside the price. A seller who agrees a headline price without agreeing how working capital will be defined has agreed to a number that can still move.

Then do the arithmetic on your own business before the buyer does: calculate what the target would be under two or three defensible definitions, and know which one you are arguing for and why. This is the same discipline that a sell-side earnings review applies to profit, and it protects money just as directly.