What is a working capital peg?
A working capital peg is the agreed normal level of net working capital, meaning current assets minus current liabilities with cash and funded debt excluded, that the seller must deliver at closing. When the business closes below the peg, the purchase price falls dollar for dollar. When the business closes above the peg, the seller collects the excess.
The peg exists because the buyer is purchasing an operating company and expects enough receivables, inventory, and prepaid expenses to run it without injecting cash on day one. The concept is fair. The methodology behind the number is where sellers lose money.
What is the working capital adjustment formula?
The adjustment itself is simple arithmetic. The complexity lives entirely in the definitions.
Net working capital for transaction purposes is current operating assets minus current operating liabilities, with cash and funded debt removed. In most lower-middle-market purchase agreements that resolves to accounts receivable plus inventory plus prepaid expenses, less accounts payable plus accrued liabilities, with deferred revenue and a handful of contested items argued in or out by negotiation.
The adjustment is then the delivered figure minus the peg. A business that closes with $1.1M of net working capital against a $1.3M peg produces a $200,000 reduction in purchase price. The same business closing at $1.5M produces a $200,000 increase, provided the agreement makes the adjustment two-way.
Nothing about that arithmetic is difficult. What decides the outcome is which line items the agreement counts, which accounting policies produce the closing balance sheet, and who carries the burden of proof when the buyer disagrees with a number. A seller who negotiates only the peg amount and accepts the buyer’s definitions has negotiated the smaller half of the problem.
Why do buyers wait until after the LOI to set the peg?
Most letters of intent state a price and defer the peg with a phrase such as a normal level of working capital to be mutually agreed. That phrase moves a six-figure negotiation into exclusivity, after the seller has dismissed every competing buyer and the buyer faces no competitive pressure.
Windsor Drake puts the peg methodology inside the letter of intent, next to price, before exclusivity begins. Roughly 1 in 3 signed LOIs fail to close on their original terms, and open peg language is one of the standard channels for that erosion.
The Proprietary Discount is the gap between what a serial acquirer pays in an unbanked bilateral negotiation and what the same business clears in a competitive process. That gap accumulates through mechanical terms like the peg as much as through the headline number, which is why Windsor Drake tracks the gap through The Windsor Drake Proprietary Discount Index.
Which peg methodology should a seller argue for?
Most deals choose among a trailing 12-month average, a seasonally adjusted average, or a point-in-time balance, and each version favors a predictable party. The buyer proposes the version that produces the highest peg, so the seller’s job is to know which version fits the business before the buyer picks one.
| Peg methodology | Who it favors | When to argue for it |
|---|---|---|
| Trailing 12-month average | Neither party in stable businesses; the seller when the close would land at a seasonal peak | The default seller ask, strongest when monthly working capital is stable or the closing date is uncertain |
| Seasonally adjusted average | The party whose normal season the close would otherwise misrepresent | Argue for it when working capital swings materially across the year and the likely closing month is known |
| Point-in-time balance | Whoever controls the reference date, which is almost always the buyer | Accept only when the date is contractually fixed and falls in a month that matches the normal operating level |
The exclusions matter as much as the method. Whether deferred revenue, accrued bonuses, or customer deposits sit inside or outside the calculation can move the peg more than the averaging period does.
Two further methods appear often enough to recognise on sight. A target method builds the peg from the ground up, calculating what working capital ought to be at stated receivable days, inventory turns, and payable days rather than what it has been. Buyers propose it when they believe the business has been run loosely, and it imports a judgment about optimal performance that no historical average contains. A seller facing a target-method peg is being asked to deliver the working capital of a better-run company than the one being sold.
A minimum method sets a floor instead of a target: deliver at least the stated figure and keep any excess. It appears in fast-growing businesses where historical averages understate real requirements, in businesses too volatile to normalize, and in deals where the seller has genuine leverage. It is the most seller-favorable structure in common use, and it is worth asking for even when the answer is no, because the response tells you how much competitive pressure the buyer actually feels.
How much does the wrong methodology cost a seasonal business?
Take a hypothetical software company that invoices 70 percent of its annual maintenance in the first quarter. Receivables swell in March and drain through the year, so month-end net working capital runs from $1.6M in March down to $0.9M in October, with a trailing 12-month average of $1.2M.
A buyer pegging off the March balance sheet sets the target at $1.6M. A close in October delivers $0.9M of actual working capital, and the seller absorbs a $700,000 price reduction on a business operating exactly as it always has.
A trailing 12-month average peg of $1.2M cuts the same adjustment to $300,000. A seasonally adjusted peg measured against normal October levels cuts it to zero. On this fact pattern the methodology choice alone is worth six figures.
What the working capital adjustment looks like from the finance seat
Almost everything published about working capital adjustments is written by advisers looking at the mechanism from outside the company. What follows is the view from inside it, where the numbers are produced rather than analysed.
The first thing a seller discovers is that nobody owns the closing balance sheet. Every other recurring number in a company has a person attached to it. The closing balance sheet has a deadline, usually five to ten business days after a closing that has just consumed the entire finance function, and no owner until someone is assigned. Sellers who name that person before signing deliver a defensible statement. Sellers who do not deliver whatever the controller could assemble in a week that also contained a closing, and then spend sixty days defending it.
The second is that a buyer’s diligence team does not accept a system report as evidence. A seller who is asked why inventory is carried at $4.2M and answers that the system says $4.2M has not answered the question. The buyer is asking what the reserve policy is, when it was last applied, what has not moved in a year, and what the recovery would be if it were sold today. A number that has never been challenged internally is not a number that survives being challenged externally.
The third is that under-accrual is the most common finding and it is almost never deliberate. Companies accrue what they invoice for and miss what arrives late: the professional fees for the quarter that has not been billed, the rent escalation nobody applied, the commission true-up that runs one period behind. None of it matters while the business is owned by the person running it, because it corrects itself the following month. At a closing date it is a permanent transfer of money, because every accrual the buyer adds to the closing balance sheet reduces delivered working capital dollar for dollar.
The fourth is that the cutoff argument is won with documents, not with policy language. The purchase agreement will say that the closing statement is prepared on the company’s historical accounting policies, and that clause is worth having. It does not settle whether a particular shipment left the dock before midnight. Shipping records, carrier confirmations, and signed delivery receipts settle that, and the seller who has them organised before closing wins the argument in an afternoon rather than a month.
Inventory, reserves, and the numbers a buyer will test
In any business that carries inventory, the working capital adjustment is mostly an argument about inventory, and inventory carried at cost is not always inventory worth cost.
Four categories account for most of the money. Obsolescence is the largest: stock that is on hand, in the system at full value, and has not moved in twelve or eighteen months. Overhead absorption follows, where manufactured or assembled goods carry allocated costs that a buyer will argue overstate value. Then scrap and shrinkage, where the reserve has been set by habit rather than by count. Then, in businesses with work in process, the stage-of-completion judgment that decides what a partially finished unit is worth.
The same discipline applies to receivables. A buyer conducting a post-closing aging analysis will propose reserves against specific customers, and the seller who assured the buyer during diligence that those customers were good now has to prove it. Payment history, credit terms, and the account’s behaviour over the prior two years are the evidence. Assurance is not.
The practical point is that all of this is cheaper to resolve before a buyer is contacted than after a purchase agreement is signed. A seller who counts, reserves, and documents inventory on a normal Tuesday sets the reserve. A seller who does it under a sixty-day post-closing review is negotiating against someone whose analyst has nothing else to do.
This is the work Windsor Drake’s transaction finance review is built to do, and the reason the firm asks a chief financial officer rather than a banker to review the file.
How does the post-closing true-up work?
At closing the parties settle against an estimated balance sheet. Within 60 to 90 days the buyer delivers a final closing statement, the difference between estimate and actual is settled dollar for dollar, and disputed items go to an independent accountant named in the purchase agreement. The seller then has a stated window, commonly 30 to 45 days, to object in writing. Objections not raised inside it are usually deemed accepted, which makes that review period one of the few genuine deadlines in a purchase agreement and a bad one to discover late.
A net working capital collar softens the mechanic. The collar creates a dead band around the peg, stated either as a dollar amount or as a percentage, inside which no adjustment is made in either direction. A $50,000 collar on a $1.3M peg means the price moves only if delivered working capital falls outside the range of $1.25M to $1.35M. Percentage collars of roughly 5 to 10 percent of the peg appear in the same role.
Collars cut both ways and that is the point of them. The seller gives up the small upside for protection against the small downside, and both sides avoid a post-closing argument over an amount neither would choose to litigate. They are more common in smaller deals and less common where the parties want precision. A collar is not a substitute for a defensible peg, but on a business with genuinely volatile month-end balances it removes a whole category of friction.
Sellers should also push for a cap on downward adjustments, and should read the adjustment clause specifically to confirm it is two-way. Buyer drafts that reduce the price for a shortfall while capping or omitting payment for an excess are not unusual, and the asymmetry is easy to miss because it sits in the mechanics rather than in the price.
Is deferred revenue debt or working capital?
Deferred revenue is the single biggest peg fight in software transactions. The buyer’s position is that deferred revenue is a debt-like obligation to deliver service customers already paid for, so it belongs in the net debt bridge at or near face value. The seller’s position is that deferred revenue is an ordinary operating liability that recycles every month, costs far less than face value to fulfill, and belongs inside working capital where the peg absorbs it.
Negotiated outcomes span the full range between those positions, and many deals settle in the middle by valuing the obligation at the cost of fulfilling it plus a margin rather than at the revenue the customer was billed. That is usually the seller’s best available compromise, because it prices the liability the buyer actually inherits instead of the invoice. Serial software acquirers such as Volaris and Valsoft run this negotiation many times a year; the founder across the table runs it once.
How the adjustment changes by business model
A generic peg analysis fails on any business with a distinctive working capital shape, and the shape is set by the business model rather than the sector label.
Software and subscription businesses
Little inventory, modest payables, and a deferred revenue balance that dominates everything else. The entire negotiation is the deferred revenue question covered above, plus the treatment of annual prepayments that land in a single month. Sellers should model the peg against the invoicing calendar, not the fiscal year.
Distribution, manufacturing, and inventory businesses
The most exposed model, because inventory is both the largest component and the most contestable. Obsolescence reserves, overhead absorption, consignment arrangements, and supplier rebate accruals all carry judgment, and every judgment is a place the buyer can propose a different number. These businesses also tend to have concentrated receivables, which invites customer-specific reserve arguments.
Healthcare and insurance-billed services
A long gap between service delivery and payment, with a meaningful share of billed revenue never collected. The peg has to reflect the real revenue cycle while distinguishing receivables that will collect from those that will be denied, adjusted, or written off. Historical collection rates by payer are the evidence, and sellers who cannot produce them accept the buyer’s estimate.
Construction and project-based businesses
The hardest of the four. Retainage receivable may not be collected for twelve to eighteen months, work in process requires percentage-of-completion judgment, and overbilling and underbilling positions swing with the project calendar rather than the month. Standard trailing-average methodologies frequently produce a peg that has no relationship to the business, and these sellers should expect to build the methodology themselves rather than react to a buyer’s draft.
How do buyers use the peg to retrade the price?
The peg is the quietest retrade channel in a deal because it never has to be called a price cut. A buyer that proposes a $400,000 higher peg in week six of exclusivity has cut the price by $400,000 while framing the move as accounting.
The tactic works late in exclusivity, when the seller has spent months of attention and $75,000 to $150,000 of legal budget on a $20M deal and does not want to restart. The pattern belongs to the same family of post-LOI pressure covered across Windsor Drake’s offer-received guides.
What should my accountant prepare before any LOI?
Instruct your accountant to build a monthly net working capital schedule covering at least 24 months, stated on the same basis the purchase agreement will use, with cash, funded debt, and contested items broken out. Add a deferred revenue waterfall showing how balances convert into delivered service.
From that schedule, table your own peg and methodology during the LOI negotiation. The seller who presents a documented peg first anchors the number; the seller who waits negotiates against the buyer’s draft inside exclusivity.
If a buyer’s letter of intent is in front of you and the peg is still an open phrase, Approach Response is the Windsor Drake engagement that fixes the methodology before exclusivity starts.
Questions founders ask
What is a typical working capital peg amount?
No standard amount exists because the peg reflects each company’s normal operating level. The defensible anchor is a trailing 12-month average of monthly net working capital, calculated on the same accounting basis the purchase agreement will use. The methodology, not a benchmark figure, determines whether the peg is fair.
Can the working capital peg be negotiated in the LOI?
Yes, and it should be. The LOI can state the methodology, the exclusions, and even a provisional peg figure. Buyers resist because an open peg preserves a repricing channel inside exclusivity, and buyer resistance to peg language in the LOI is itself information about intent.
Does cash count in the working capital peg?
No in most lower-middle-market deals. Transactions run cash-free and debt-free, so cash and funded debt sit outside the peg and settle separately in the equity value bridge. The fights concentrate on items that resemble both categories, such as deferred revenue and customer deposits.
What happens if working capital at close is above the peg?
The purchase price increases dollar for dollar under a standard two-way adjustment. Sellers should confirm the adjustment is genuinely two-way, because some buyer drafts adjust downward for shortfalls while capping or eliminating upward payments for any excess the seller delivers.
How is deferred revenue treated in the peg for a software company?
Buyer drafts commonly treat deferred revenue as a debt-like item at or near face value, while sellers argue it belongs inside working capital as a recycling operating liability. Negotiated outcomes span the full range between those positions, and the treatment often moves more money than the peg methodology itself.
Who resolves a working capital dispute after closing?
The purchase agreement names an independent accounting firm as arbiter, and its determination on the disputed items is final. The true-up settles within 60 to 90 days of closing in most deals, so disputes surface while escrow funds remain available to satisfy them.
What is a working capital adjustment in M&A?
A working capital adjustment is a post-closing change to the purchase price that compares the net working capital actually delivered at closing against an agreed target called the peg, and moves the price dollar for dollar for the difference. It exists so the buyer receives a business carrying enough receivables, inventory, and prepaid expenses to operate without injecting cash on day one.
What is a net working capital collar?
A collar is a dead band around the peg inside which no adjustment is made in either direction, stated either in dollars or as a percentage of the peg. A $50,000 collar on a $1.3M peg means the price moves only if delivered working capital lands outside $1.25M to $1.35M. Collars remove arguments over immaterial variances and cut both ways, so the seller gives up small upside for protection against small downside.
How is the working capital adjustment calculated?
Net working capital is current operating assets minus current operating liabilities with cash and funded debt excluded, which in most lower-middle-market agreements means receivables plus inventory plus prepaid expenses, less payables plus accrued liabilities. The adjustment is that delivered figure minus the peg. The arithmetic is simple; the money is in which line items the agreement counts and which accounting policies produce the closing balance sheet.
Last reviewed August 27, 2026 by Jeff Barrington, Founder and Managing Director, Windsor Drake, and reviewed for transaction finance by Michael Culhane, Senior Advisor. Content on this page may be cited with attribution and a link to https://windsordrake.com/valuation/working-capital-peg/