The working capital peg is the mechanism in a business acquisition that ensures the seller leaves enough cash, receivables, and inventory in the business at close to fund normal operations — rather than stripping the business dry before handing over the keys. It is often an afterthought in the LOI and one of the most contested items in purchase agreement negotiations. Getting it right protects you from a day-one liquidity crisis.
What Working Capital Is and Why It Matters
Working capital (WC) is current assets minus current liabilities. In a business context, the relevant components are accounts receivable, inventory, and prepaid expenses on the asset side; and accounts payable, accrued expenses, and deferred revenue on the liability side. Cash is typically excluded from the WC calculation in acquisitions (it is treated separately as a debt-free, cash-free closing adjustment).
A business needs working capital to operate. It needs to pay employees before it collects receivables. It needs to hold inventory before it processes orders. If the seller spends down receivables or defers payables before close, you can inherit a business that technically meets the purchase price but is immediately cash-negative in week one.
How the Peg Mechanism Works
You agree in the LOI (or the definitive agreement) on a target working capital amount — the WC the seller will deliver at close. This number is typically based on the trailing 12-month average WC or a rolling six-month average, representing "normal" operations. At close, actual WC is calculated from the closing balance sheet. If actual WC is above target, the purchase price increases dollar-for-dollar. If actual WC is below target, the purchase price decreases dollar-for-dollar.
Example: you agree to a $5M purchase price and a $600K WC target. If the seller closes with $520K of WC (an $80K shortfall), you pay $4.92M, not $5M. If the seller closes with $680K (an $80K surplus), you pay $5.08M.
Setting the Right Target
The target should reflect the true cash needs of the business's operating cycle. A services business with 45-day DSO and minimal payables needs less WC than a product business with 90-day inventory turns and fast-paying customers. Use the trailing 12 months of monthly WC snapshots (not just quarter-end, which can be window-dressed) to establish an average. Then apply a seasonality adjustment if the business has significant seasonal swings — you want the target set at the level appropriate for the close date, not the annual average.
The American Bar Association's 2023 Private Company M&A Deal Points study found that 42% of lower-middle-market transactions experienced working capital disputes post-close, with an average shortfall at close of approximately 8% of the agreed WC target. Deals where the WC shortfall exceeded $100K occurred in 31% of transactions; shortfalls exceeding $250K occurred in 14%. These are not edge cases.
Common Manipulation Tactics Sellers Use
Sellers in the months before close sometimes: accelerate collection of receivables (pulling forward cash), delay payment of payables (inflating the WC calculation), reduce inventory orders (cutting costs in ways that leave you with a thin supply buffer), or defer capital expenditures (reducing cash outflows but leaving you with deferred maintenance obligations). All of these tactics can make the closing WC look healthy while creating operational problems on day one.
The fix is a combination of covenants in the purchase agreement (seller agrees to operate in the ordinary course of business during the period between signing and close), a clear WC definition that covers all the relevant balance sheet items with no ambiguity, and a post-close true-up mechanism with a short settlement window (45–60 days) and a formal dispute resolution process (independent accountant arbitration is common).
What "Ordinary Course" Means and Why It Is Contested
The purchase agreement will require the seller to operate "in the ordinary course of business" between signing and close. What does this mean for WC? It means the seller should not take actions specifically designed to manipulate the WC closing calculation. It does not mean the seller cannot run the business normally. The line between "normal operations" and "manipulation" is where most WC disputes originate.
Engage your M&A attorney to define the WC target with specificity (down to the line item level) and include a covenant explicitly prohibiting any acceleration of collections or deferral of payables in the 90 days prior to close. Then plan for a post-close true-up and be prepared to hold the seller to it.