Working Capital Peg in M&A

Executive summary

A working capital peg is the target level of net working capital that a seller agrees to deliver at closing. If the business closes with less net working capital than the peg, the purchase price goes down by the shortfall. If it closes with more, the price goes up by the excess. The peg exists so a buyer who pays for a business that runs normally does not receive one that has been run lean for six weeks: receivables collected early, payables stretched, inventory run down.

The peg is a negotiated number built from a definition and a history. Both parts matter. A small change in which accounts count as net working capital, or in which months are averaged, can move the price by more than a typical debate over the headline multiple. An important boundary applies to everything below. The purchase agreement defines net working capital, the peg, the accounting principles, the dispute process, and the true-up mechanics. This article describes the method and the questions to ask. It is not legal or accounting advice. Involve your M&A counsel and your financial and tax advisers before you agree to any definition, peg, or adjustment.

When to use this

Use this guide when:

• You are preparing to sell and want to know what number a buyer will propose, and why.
• You are a buyer's operator reviewing the diligence team's peg proposal before the letter of intent hardens.
• A purchase agreement draft contains a "target working capital" and you need to test whether it fits how the business actually runs.
• The business is seasonal, growing quickly, or recently changed its terms with customers or suppliers, so a simple average is unlikely to be fair.

What net working capital means in a deal

In operating management, net working capital usually means current assets less current liabilities. In an acquisition, the definition is narrower and is written into the agreement. A typical deal definition keeps the operating items and removes the items that are dealt with elsewhere in the price.

Whether accrued bonuses, deferred revenue, customer deposits, or an income tax payable sit in net working capital or in debt changes the number twice: once in the peg and once in the price bridge. The buyer wants a liability treated as debt (dollar-for-dollar reduction in price). The seller may prefer it inside working capital, where it is averaged across a year and partly offset by other items. Neither is automatically right. What matters is that the definition is applied the same way to the historical months used for the peg and to the closing balance sheet.

The consistency rule is the most common source of disputes: the peg months and the closing statement must be prepared using the same accounts, the same accounting policies, and the same estimation methods. If the historical months were prepared with one reserve method and the closing statement with another, the peg compares unlike things.

Diagnostic questions

Work through these before the first peg discussion. Each can be answered from the general ledger and the subledgers.

1. Can you produce monthly trial balances for the last 24 months, mapped to the same chart of accounts?
2. Which accounts are in your working capital definition, and does each one have an owner who understands what drives its balance?
3. Is net working capital seasonal, and in which months does it peak and trough?
4. Has revenue grown or shrunk materially in the period, so that older months understate or overstate the current scale of the business?
5. Did customer terms, supplier terms, or inventory policy change during the period?
6. Are there one-time items inside receivables, payables, or inventory, such as a disputed balance or a settled claim?
7. Are accruals complete at each month-end, or only at quarter-end or year-end?
8. How are inventory reserves, bad debt allowances, and warranty provisions set, and have the methods changed?
9. Does the business use factoring or supply chain finance that would change balances at closing?
10. Who will prepare the closing statement, and who will review it for the other side?

If you cannot answer questions 1, 7, or 8, the peg conversation is premature. Without clean monthly balances and consistent accruals, any average is built on unstable figures.

The framework: how a peg is built

Most pegs are built in five steps. The steps are the same whether you are the buyer or the seller; what changes is which side of each judgment you argue.

Step 1: Define

Start from the balance sheet and list every current account. Mark each as included, excluded, or open. For each open item, write down who benefits from each treatment. Link every included account to the policy that drives its balance.

Step 2: Normalize

Monthly net working capital as booked is rarely the number to average. Common normalizations include removing balances that will not convert to cash in the normal course (a fully disputed receivable), adding back accruals that should have been booked, and removing non-recurring items such as a one-off inventory build for a discontinued line. The same normalization work usually appears in the quality of earnings analysis, so coordinate with the team producing it.

Each normalization needs support: an invoice, a contract, a subsequent receipt, or a policy memo. Without it, it is an opinion.

Step 3: Select the period

The default is the trailing 12 months before closing, because it captures a full seasonal cycle. Shorter periods (trailing six or three months) are more responsive to recent changes but are vulnerable to seasonality. Longer periods smooth noise but can include balances that no longer describe the business.

Your argument for a different period should rest on a specific event: a change in customer terms, an acquisition, a new product line, or a loss of a major customer. "The recent months look better for us" is not an argument; "the receivables terms moved from net 45 to net 30 in March and that change is permanent" is.

Step 4: Compute the average

A simple average of monthly balances is the common starting point. A weighted average, or an average of month-end balances adjusted for the days in each month, can matter for a fast-growing business. If most billing and payroll happen in the last week of the month, month-end balances can mislead; ask for average weekly balances where the data exist.

Step 5: Test against the closing month

Compare the proposed peg to the net working capital the business normally carries at the expected closing date. If the business peaks in the fourth quarter and closes in the second, a trailing average may be higher than normal for that month, which favors the buyer. If the business is growing, a trailing average may be lower than the level the business now needs, which favors the seller. A seasonal peg schedule, with a different peg for each possible closing month, is one way to address this. Whether it is acceptable is a negotiation and a drafting question for counsel.

Worked example (illustrative)

The numbers below are invented to show the method. They are not benchmarks, and the business does not exist.

A distributor of industrial components is being sold on a cash-free, debt-free basis. Normalized monthly net working capital for the trailing 12 months, in $ millions, is:

Trailing-12 simple average = 44.72 ÷ 12 = $3.727M, the proposed peg.

For comparison, the trailing six-month average is 3.757 and the trailing three-month average is 3.680. The three figures are close here, so the choice of period matters little in this example. In a seasonal or fast-growing business they would diverge, and the argument over the period would carry real dollars.

Reconciling one month

The last month, Month 12, is the one the buyer's team reconciles first. Reported net working capital and the adjustments to reach the normalized figure:

Check: 8.80 − 4.80 = 4.00. Then 4.00 − 0.30 − 0.12 + 0.20 = 3.78. The normalized figure ties to Month 12 in the series above.

The closing true-up

Suppose the deal closes and the closing statement shows net working capital, on the same definition and policies, of $3.30M.

Adjustment = closing NWC − peg = 3.30 − 3.727 = −$0.427M.

The purchase price is reduced by about $427,000. Had closing NWC been $4.00M, the price would have increased by about $273,000 (4.00 − 3.727).

What this tells the operator:

• A seller who collected receivables aggressively and delayed inventory purchases before closing would produce this shortfall. The peg makes that behavior cost something.
• A buyer who accepts a peg that is too low receives a business that needs cash injected early to restore normal operations.
• The $0.30M disputed receivable matters twice. If it stays in the historical months but is excluded from the closing statement, the closing figure looks worse than the peg for a reason that has nothing to do with operations. Use one rule in both places.

Step-by-step process

Counsel and your accounting advisers should review steps 2, 5, 7, and 8. The agreement controls deadlines, objection periods, who resolves disputes, and whether an independent accountant decides unresolved items. Do not assume any of these from this article.

Templates

NWC definition worksheet (copy into a spreadsheet)

Normalization log

Closing statement checklist

1. Same account list as the agreed definition.
2. Same accounting policies and estimation methods as the peg months.
3. Cut-off tested for receipts, shipments, and payments around the closing date.
4. Subsequent receipts and payments reviewed for the first weeks after closing.
5. Reserves recomputed under the agreed method, not a new one.
6. Disputed items listed separately with documents attached.

Metrics and KPIs

Setting the target by method. The seller's anchor is the series of its own normalized months and the policy changes that justify a different period. The buyer's anchor is the level the business needs to operate at the expected closing month, tested against its own forecast. Where the two diverge, the contract is the reference: the peg is whatever the agreement says, and the definition in the agreement controls over any internal view. Do not take a peg or a percentage-of-revenue figure from another deal and apply it here.

Common mistakes

1. Negotiating the number before the definition. Agree what is in net working capital first. A peg of $3.7M under one definition and under another are different promises.
2. Using a different method at closing than in the peg months. Reserve methods, accrual cut-offs, and inventory costing must match, or the true-up measures the accounting change instead of the business.
3. Ignoring seasonality. A trailing 12-month average applied to a closing in a seasonal peak or trough shifts value between the parties without any change in performance.
4. Treating growth as noise. A business that grew a lot needs more working capital now than older months suggest.
5. Leaving normalizations unsupported. Each add-back and removal needs a document. Unsupported ones are the first to be struck.
6. Managing the balance sheet before closing. Collecting early and paying late creates a cash windfall that the peg is designed to offset. Buyers should watch weekly receipts and payments in the final 60 days.
7. Skipping counsel on the mechanics. The objection period, the independent-accountant clause, and the definition of accounting principles decide who wins a dispute. Read them early, with your advisers.

AI prompt assistance

Use AI to prepare analysis and draft schedules. Do not use it to decide a definition or to interpret an agreement; those are for counsel and your advisers. Supply the data yourself and verify every figure against the ledger.

1. Build the normalized series.

I will paste 24 months of trial balance lines tagged with an account category, and a list of proposed normalizations with amounts and months. Produce a monthly table of included current assets, included current liabilities, reported NWC, normalizations, and normalized NWC. Then compute the trailing 12, 6, and 3-month simple averages. Show every step.

Check: recompute one month by hand and confirm that the sum of monthly figures matches your total.

2. Surface unusual movements.

Here is the monthly normalized NWC series and the revenue for each month. List the months where NWC changed by more than the change in revenue would explain, and suggest the account-level questions I should ask the controller. Do not guess causes; list questions only.

Check: confirm each flagged month against the subledger before raising it with the other side.

3. Draft the closing statement review list.

Given this NWC definition (pasted), draft a checklist of what to compare between the peg months and the closing statement: accounts, accounting policies, cut-off, reserves, and subsequent receipts. Mark each item that depends on a contract clause so I can ask counsel.

Check: have counsel review the list against the actual agreement.

Implementation guide

Timing varies by deal. Use the dates in the agreement for the true-up.

After closing, compare actual net working capital each week to the peg and the plan, and feed the findings into the PMI playbook.

Downloadable assets

The NWC definition worksheet, normalization log, and closing statement checklist above are designed to be copied into a spreadsheet. To test a peg against your own monthly balances, use the working capital peg estimator. It is an estimating aid and does not replace the agreement or your advisers.

Related resources

• Due diligence hub: the full set of diligence guides.
• Financial due diligence checklist: the workstream that produces the monthly balances.
• Quality of earnings report before you close: where normalizations to earnings and working capital overlap.
• Working capital playbook: the operating levers behind receivables, inventory, and payables.
• Operational due diligence checklist and commercial due diligence red flags: context that explains balance movements.
• Technology due diligence for operators and people and organization due diligence: accrual and system questions.
• PMI playbook: Day 1 to Day 365: funding and managing working capital after closing.

Frequently asked questions

What is a working capital peg?

A working capital peg is the target amount of net working capital that the seller agrees to deliver at closing. If closing net working capital is below the peg, the price is reduced by the shortfall; if above, it increases. The agreement defines both the peg and what counts as net working capital, so read it with your counsel.

How is a working capital peg calculated?

A peg is usually the average of normalized monthly net working capital over a representative period, often the trailing 12 months before closing. Parties first agree which accounts are included, then adjust months for supported one-time items, then choose simple or weighted averaging. Seasonality, growth, and term changes can justify a different period, and the agreement controls the final number.

Who benefits from a high or low peg?

A higher peg benefits the buyer, because the seller must deliver more working capital or accept a lower price. A lower peg benefits the seller. Neither side should chase the extreme. The fair peg is the level the business normally needs to operate at the expected closing date, supported by documented monthly balances.

Is cash included in net working capital?

Cash is typically excluded from net working capital in a cash-free, debt-free deal, and is dealt with in the price bridge instead. The same often applies to interest-bearing debt and income taxes. Treatment varies by agreement, so confirm the exact definition with counsel and your advisers before you rely on any figure.

What happens if the buyer and seller disagree on closing working capital?

The purchase agreement sets the process, usually a closing statement, a review and objection period, negotiation, and sometimes an independent accountant for unresolved items. The details, including deadlines and the scope of review, differ by deal. Ask counsel to walk you through the clause before you sign, not after a dispute starts.

How this works in a System of Performance

A peg is only as good as the monthly balances behind it, and most companies reassemble those balances by hand during a deal. A Performis routine can take on a recurring job like this, with the scope and fit agreed with you: it works from the records your team supplies, prepares the work for your named reviewer, and keeps each approval on record. To see how your own working capital behaves month to month, bring it to us as a launch partner.