Key takeaways
- Working capital peg adjustments can reduce net proceeds by $500K–$2M or more on a $10M deal
- The peg is set during LOI negotiation, after signing, the methodology is locked
- Cash-free, debt-free is the standard deal structure, but "debt" has a broader definition than founders expect
- Deferred revenue and customer deposits are almost always the biggest surprise
What working capital actually means in a transaction
Working capital in a transaction context means current assets minus current liabilities, with specific items included and excluded based on the deal structure. The standard structure is "cash-free, debt-free", the seller keeps cash and repays debt at close, and the business is delivered with a normalized level of working capital.
The working capital peg is the agreed target level of working capital that should be in the business at closing. If closing working capital is above the peg, the buyer pays more. If it is below the peg, the seller receives less. The delta goes dollar for dollar. On a business where working capital typically runs $2.5M and closing comes in at $1.8M, the seller gives back $700K.
Key working capital definitions
Working capital
Current assets minus current liabilities, with specific items per deal agreement
Peg
The target working capital level at closing, typically a trailing 12-month average
Peg period
The timeframe used to set the peg, usually trailing 12 months, sometimes the most recent fiscal year
Cash-free debt-free
Standard structure: seller retains excess cash, all debt repaid at close
Debt-like items
Liabilities treated as debt even if classified as current liabilities, e.g., deferred revenue, customer deposits, accrued PTO
The items that most often surprise sellers
Most founders understand that accounts receivable and accounts payable are in working capital. What surprises them are the items that buyers treat as "debt-like" and exclude from working capital or treat as dollar-for-dollar adjustments to the purchase price.
Deferred revenue|Recognized as a liability on the balance sheet; buyer treats as debt-like because they must deliver the service post-close without corresponding cash
Customer deposits|Same treatment as deferred revenue, buyer inherits the obligation
Accrued paid time off|If employees carry over PTO, the accrued liability is often treated as debt
Earnout-linked liabilities|Bonus accruals tied to performance that crosses fiscal year
Seller-paid customer credits|Credits issued pre-close that the buyer must honor post-close
Lease make-whole provisions|If a real estate lease has unfavorable terms relative to market, buyer may treat the overage as a price reduction
A manufacturing business sold for $14.5M on 6.5x EBITDA. The seller had approximately $1.1M in deferred revenue on the balance sheet from annual service contracts billed in January for the full year. The buyer treated all deferred revenue as a debt-like item, the seller would receive cash for work not yet performed, and the buyer would be required to deliver that work post-close. The deferred revenue adjustment reduced net proceeds by $1.1M. The seller had not modeled this in their expected proceeds calculation. The effective enterprise value received was $13.4M, not $14.5M.
How the peg is set and why it matters
The working capital peg is negotiated during the LOI stage, not the purchase agreement stage. After LOI signing, the methodology is essentially locked. The buyer will commission a quality of earnings analysis that includes a working capital assessment, and the purchase agreement will be drafted around whatever peg methodology was agreed in the LOI.
The most common peg methodology is trailing 12-month average working capital, calculated monthly. This tends to smooth seasonality. Some buyers push for spot (most recent month end) or last fiscal year end, both can be more or less favorable depending on the business's seasonal pattern and when in the year the deal closes.
Peg methodology comparison for seasonal businesses
What to do before you go to market
The single most valuable preparation step for working capital is a self-assessment of what the buyer will treat as debt-like. Walk through every liability on your balance sheet with your accountant and your advisor. For each one, ask: will the buyer treat this as a working capital item or a debt-like item? The answer determines how proceeds are calculated.
If you have significant deferred revenue or customer deposits, model the peg adjustment explicitly before you start a process. Know what your trailing 12-month average working capital is. Know what it would be if deferred revenue were excluded. That delta is real money at closing.
One of the highest-ROI conversations you can have before engaging a banker is a two-hour working capital review with a sell-side advisor. The goal is not to manipulate the number, it is to understand it so you are not surprised at close, and so you can negotiate the peg methodology with full information during the LOI stage when leverage still exists.
Frequently asked questions
What is the working capital peg in an M&A transaction?
The working capital peg is the target level of working capital agreed between buyer and seller. If the business delivers more than the peg at closing, the buyer pays more. If it delivers less, the seller receives less. It is typically set as a trailing 12-month average of monthly working capital and negotiated as part of the LOI.
What are debt-like items in a transaction?
Debt-like items are balance sheet liabilities that the buyer treats as economically equivalent to debt, the seller must repay or absorb them as a price adjustment. Common examples include deferred revenue, customer deposits, accrued PTO, and certain earnout-linked bonus accruals.
Can working capital adjustments be negotiated?
Yes, and the best time to negotiate them is before LOI signing. After signing, the methodology is locked. A seller who understands which items will be treated as debt-like can push for a more favorable peg methodology or negotiate specific items out of the adjustment mechanism during the LOI stage.
Work with Glacier Lake Partners
Get help modeling your working capital peg
Working capital adjustments at closing can shift net proceeds by hundreds of thousands. We help founders model the peg before the LOI.
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