What is a working capital peg? Definition, formula and example

This post is for buyers and sellers who have reached the purchase agreement and met the words "working capital peg" for the first time. By the end you will know what the peg is, how net working capital is calculated, how the peg is set from twelve months of balance sheets, and how the price is adjusted at closing.

The definition in plain words

A working capital peg protects the buyer from paying full price for a business that arrives empty. To run from day one, a business needs a normal stock of receivables, inventory and prepaid costs, less the bills it owes. The peg is that normal level, agreed in advance. Investopedia's working capital page covers the accounting idea; in a deal, the peg is the version the two sides sign.

Without a peg, a seller could collect every receivable, stop ordering stock and stretch every supplier in the month before closing. The seller walks away with the cash; the buyer has to fund the gap. The peg stops that.

The formula

Two steps: work out net working capital on each balance sheet, then set the peg as the average.

Net working capital (NWC) = current assets excluding cash − current liabilities excluding debt

Cash is left out because the seller usually keeps it. Debt is left out because the seller usually pays it off at closing. What remains is receivables, inventory and prepaid costs on one side, and payables and accrued expenses on the other.

Peg = average NWC over the trailing twelve months

Price adjustment at close = NWC delivered − peg

A positive number means the buyer pays more; a negative number means the price comes down. Many agreements add a small "collar" either side of the peg within which no adjustment is made.

Illustrative example: a $1,800,000 distribution business

The table shows twelve month-end NWC figures from the seller's balance sheets, the peg, and the true-up at closing.

At closing the balance sheet shows receivables of $300,000, inventory of $120,000 and prepaids of $15,000, less payables of $40,000 and accrued expenses of $10,000. That is $435,000 − $50,000 = $385,000. The peg is $410,000, so the buyer pays $1,775,000 instead of $1,800,000. Had the seller delivered $430,000, the buyer would have paid $20,000 more.

Where it shows up in a deal

The letter of intent usually says only that "a normal level of working capital" comes with the business. The number is set during due diligence, once the buyer's accountant has seen twelve or more month-end balance sheets. The purchase agreement then records the definition, the peg and any collar. It also sets the process for the final count, usually 60 to 90 days after closing.

Buyers can see where this fits among the other steps in our guide on how to buy a business. Sellers should read how to sell a business and keep clean month-end balance sheets for a year before listing. A peg argument is much shorter when the numbers are already there. Lenders care too: an SBA 7(a) loan can include working capital, and the SBA's 7(a) loan page sets out the program.

Common mistakes

• Using the latest month instead of an average. One month is easy to game. Twelve months smooths out seasons and the seller's last-minute collections.
• Leaving cash or debt in the definition. They are dealt with separately. Mixing them in double-counts the price.
• Ignoring seasonality. A landscaping business has high receivables in summer. Some deals use the same month in prior years, or a seasonal peg, rather than a flat average.
• Bad receivables in the count. Agree that invoices over 90 days old, and obsolete stock, are excluded or reserved.
• No process for the final count. Name who prepares the closing balance sheet, who can challenge it, by when, and which accountant breaks a tie.
• Sellers not managing to the peg. A seller who lets receivables run up to $480,000 at closing is handing the buyer $70,000 of value unless the agreement adjusts upwards.