Key Takeaways
- The working capital peg sets the baseline the seller must deliver at closing. Shortfalls reduce the purchase price. Excesses increase it. The adjustment is symmetric and can be material.
- Cash and debt are excluded from the working capital calculation. They are handled separately as part of the cash-free, debt-free pricing convention used in most acquisitions.
- The true-up period runs 60 to 90 days post-closing. Disputed items go to an independent accountant whose determination is binding. Poorly drafted methodologies generate disputes that cost more to resolve than the amount in question.
- Quality of earnings analysis directly informs where the peg should be set. A QoE that surfaces seasonal working capital patterns or abnormal pre-closing balance sheet movements protects the buyer during true-up.
In most M&A transactions, the purchase price agreed to at signing is not the final amount that changes hands at closing. One of the most common post-signing adjustments is the working capital adjustment, a mechanism designed to ensure the seller delivers the business with a normal, operational level of current assets relative to current liabilities.
Without a working capital adjustment, a seller could strip cash out of the business, collect receivables early, defer payments to vendors, and pocket the proceeds. The buyer would close on a shell of the business they underwrote. The working capital adjustment prevents that outcome by anchoring the closing balance sheet to a negotiated target, called the peg, and reconciling the actual closing position against that target after the fact.
Understanding how the peg is set, what goes in and out of the calculation, and how disputes are resolved is essential for any buyer or seller navigating a private company acquisition. This guide is part of the broader M&A deal structures resource and builds on the framework introduced in the business purchase agreement guide.
If you are still orienting to the full transaction process, the complete guide to buying a business provides that foundation before diving into mechanics like these.
What a Working Capital Adjustment Actually Does
A working capital adjustment is a post-closing purchase price correction mechanism. It compares the actual net working capital delivered by the seller at closing against a pre-agreed target, the peg, and adjusts the final purchase price accordingly.
The underlying logic is straightforward. A business needs a baseline level of current assets, primarily receivables, inventory, and prepaid expenses, to operate day to day. Those assets are funded in part by current liabilities such as accounts payable and accrued expenses. The difference between the two is net working capital. If the seller delivers more working capital than the agreed peg, the buyer has received extra assets and must pay for them. If the seller delivers less, the buyer received a business with a funding gap and is entitled to a price reduction.
The adjustment is calculated on a dollar-for-dollar basis. A $200,000 shortfall means the seller owes the buyer $200,000. A $150,000 surplus means the buyer owes the seller $150,000. There is no threshold below which the adjustment is ignored, unless the parties negotiate a collar or band, which some transactions include to avoid disputes over minor fluctuations.
The Basic Mechanics in Three Steps
The working capital adjustment is one of several price adjustment mechanisms that appear in acquisition agreements. Earnouts, indemnification holdbacks, and deferred consideration all serve related but distinct purposes. This article focuses specifically on working capital and how it interacts with the closing balance sheet. For the full picture of deal structure options, see the M&A deal structures guide.
How the Target Working Capital Peg Gets Set
Setting the peg is one of the most consequential negotiations in the purchase agreement process. A peg that is set too high advantages the buyer, who can claim a shortfall on amounts that represent normal seasonal variation. A peg set too low advantages the seller, who can deliver less working capital than the business operationally requires and pocket the difference.
The standard methodology is to calculate average net working capital over the trailing twelve months (TTM) or over multiple trailing periods, typically two to three years. The trailing average smooths out seasonal fluctuations and one-time events that would distort a single-period snapshot. If the business has a strong seasonal pattern, the parties may use a more sophisticated method such as a month-by-month average for the applicable closing month across prior years.
The negotiation over the peg often involves competing calculations. The seller typically prefers a lower peg, calculated using periods when working capital was at its seasonal low, to make it easier to meet or exceed the target. The buyer prefers a higher peg, calculated using the trailing average, to ensure they receive a fully operational business. Both parties usually engage their accountants or financial advisors to prepare competing analyses during the purchase agreement negotiation.
Negotiation note: The peg methodology matters as much as the final dollar amount. A peg defined as "the average monthly net working capital for the trailing twelve months ended the calendar month prior to closing" will produce a different result than "the average monthly net working capital for the trailing twenty-four months." Buyers and sellers should resolve the methodology, not just the number, in the purchase agreement.
In smaller transactions, particularly those involving owner-operated businesses where the seller has been managing cash aggressively, the peg negotiation can be contentious. The LOI should address working capital methodology at a high level to prevent this from becoming a deal-breaker at the purchase agreement stage. See the LOI versus purchase agreement guide for how these mechanics are typically allocated between the two documents.
Components of Working Capital: Current Assets and Current Liabilities
Working capital is defined as current assets minus current liabilities, subject to the specific inclusions and exclusions negotiated in the purchase agreement. Not every current asset and not every current liability appears in the working capital calculation. The agreed scope is documented in a working capital methodology exhibit attached to the purchase agreement.
Current assets typically included in the working capital calculation:
Accounts receivable: Amounts owed by customers for goods or services already delivered. The working capital calculation typically applies aging adjustments: receivables older than 90 to 120 days may be excluded or included at a discount reflecting collectability risk. The treatment of aged receivables is a common negotiating point.
Inventory: Raw materials, work-in-progress, and finished goods. Inventory is typically valued at the lower of cost or net realizable value, using the same method consistently across the measurement periods. A change in inventory valuation method between periods is a manipulation signal buyers should flag during due diligence.
Prepaid expenses: Payments made for services or benefits not yet consumed, such as prepaid insurance, prepaid rent, or prepaid software subscriptions. These represent future value the buyer receives and are typically included in working capital.
Other current assets: Deposits, short-term receivables from related parties (if included by agreement), and other items with a short-term conversion cycle. Each item should be specifically addressed in the methodology exhibit to avoid disputes.
Current liabilities typically included in the working capital calculation:
Accounts payable: Amounts owed to vendors and suppliers for goods or services already received. A seller who delays payments to vendors in the weeks before closing artificially deflates payables, inflates working capital, and transfers the payment obligation to the buyer. The true-up process is designed to catch this.
Accrued expenses: Expenses incurred but not yet paid or invoiced, including accrued wages, accrued benefits, and accrued commissions. These are real liabilities that the buyer will need to pay post-closing and must be included in working capital to reflect the full current liability picture.
Deferred revenue: Customer payments received for services not yet performed. The treatment of deferred revenue is one of the most contested items in working capital negotiations. Sellers argue that deferred revenue is cash already received and should not reduce working capital. Buyers argue that performing the underlying service will cost money and the liability should be included. Most purchase agreements resolve this through a specific negotiated treatment in the methodology exhibit.
Customer deposits and advances: Similar to deferred revenue, these represent obligations to perform that the buyer inherits. Their inclusion or exclusion should be negotiated explicitly.
What Gets Excluded: Cash, Debt, and Debt-like Items
Private company acquisitions are almost universally structured on a cash-free, debt-free basis. This means the seller retains all cash on the balance sheet and pays off all outstanding debt at or before closing. The buyer receives the operating business without excess cash and without inherited debt obligations. Working capital adjustments operate within this framework by excluding cash and debt from the calculation entirely.
Cash is excluded from working capital because it is handled separately: the seller takes all cash out. If cash were included in working capital, the seller could load the balance sheet with cash before closing and inflate the working capital delivered, requiring the buyer to pay more for what is essentially the seller's money.
Debt, including lines of credit, term loans, equipment financing, and capital lease obligations, is excluded from working capital for the same reason. The seller pays these off from the closing proceeds. If debt were included in working capital as a current liability, the buyer would receive a credit that is already being accounted for in the debt payoff at closing, creating a double benefit.
Common Debt-like Items That Require Careful Treatment
- ✓Accrued but unpaid bonuses: Often treated as debt-like items paid off at closing, not as working capital liabilities.
- ✓Unfunded pension liabilities or deferred compensation: Typically excluded from working capital and addressed separately.
- ✓Outstanding checks not yet cleared: Can create a timing mismatch if the bank balance shows cash that has been committed.
- ✓Short-term portions of long-term debt: Excluded from working capital, captured in the debt payoff schedule at closing.
- ✓Seller transaction costs: Legal fees, broker commissions, and advisory costs are seller expenses paid from closing proceeds, not working capital liabilities.
The definition of what constitutes debt-like items varies by transaction and must be enumerated in the purchase agreement. Ambiguity about whether a particular obligation is a working capital liability or a debt-like item has generated some of the most expensive post-closing disputes in M&A. The asset purchase agreement guide covers how these definitions appear in asset deals specifically.
The Estimated Closing Statement
Because the actual closing-date working capital cannot be known with precision until after the deal closes and the books are finalized, purchase agreements use a two-step process: an estimated closing statement at signing or just before closing, followed by a final calculation and true-up after closing.
The estimated closing statement is typically prepared by the seller and delivered to the buyer three to five business days before the anticipated closing date. It represents the seller's best estimate of the working capital components as of the expected closing date, based on current balance sheet data. The buyer reviews this estimate and may object to specific items, but the process is designed to be quick. This is not the final determination; it is the basis for calculating the closing payment.
If the estimated working capital meets the peg, the buyer pays the full agreed purchase price at closing. If the estimated working capital is below the peg, the buyer pays a reduced amount (reduced by the estimated shortfall). If it is above the peg, the buyer pays the full price plus the estimated surplus. These estimated adjustments are then reconciled against the final calculation during the true-up.
What the Estimated Closing Statement Typically Includes
- ✓A line-by-line balance sheet for current assets and current liabilities as of the projected closing date
- ✓Confirmation of the cash balance to be retained by the seller
- ✓The closing debt payoff schedule listing all obligations to be retired at closing
- ✓A calculation of the estimated purchase price adjustment based on the difference between estimated working capital and the peg
- ✓Supporting documentation for material balance sheet items, particularly receivables aging and inventory counts
Buyers who receive an estimated closing statement with limited supporting documentation are at a disadvantage. The due diligence process should establish the baseline balance sheet clearly enough that the estimated closing statement can be reviewed quickly and with confidence. See the M&A due diligence guide for how financial due diligence feeds directly into the closing mechanics.
The True-Up Period After Close
The true-up period is the post-closing window during which the buyer prepares the final working capital calculation, the seller reviews it, and the parties settle any difference between the estimated and actual working capital figures. Most purchase agreements set this window at 60 to 90 days post-closing.
The process typically runs as follows. Within 30 to 60 days of closing, the buyer delivers a formal post-closing working capital statement. This is prepared using the same methodology as the peg, applied to the actual closing-date balance sheet. The statement identifies each working capital component, calculates total working capital, compares it to the peg, and states the resulting adjustment.
The seller then has a review period, typically 30 days, to examine the buyer's calculation. During this period, the seller has access to the underlying books and records, and the buyer is required to cooperate with reasonable information requests. If the seller agrees with the buyer's calculation, the settlement payment is made within a specified number of days. If the seller disagrees with any items, a formal objection notice triggers the dispute resolution process.
Practical note: Sellers who fail to raise a timely objection within the review period typically lose the right to dispute the buyer's calculation regardless of the merits. Purchase agreements are strict about the objection deadline. Sellers should engage their accountants promptly once the buyer's post-closing statement arrives, not at the end of the review period.
The true-up is settled in cash between the parties or drawn from an escrow account if one was established at closing. In deals where the buyer anticipates a significant working capital risk, requiring the seller to fund an escrow specifically for the working capital adjustment at closing provides security against a seller who cannot pay after the fact. This is separate from the indemnification escrow, which serves a different purpose.
How Disputes Get Resolved: The Independent Accountant Process
When the buyer and seller cannot agree on the working capital calculation after the review period, the dispute goes to an independent accountant who serves as a neutral expert. This is not arbitration. The independent accountant is an accounting expert applying accounting principles to disputed factual questions, not a legal arbitrator deciding matters of contract interpretation.
The purchase agreement specifies the scope of the independent accountant's authority. The accountant can only rule on items specifically identified in the seller's objection notice. Items that were not objected to in writing are deemed accepted. This structural constraint means that the seller's objection notice must be complete and precisely identify every disputed item, with the seller's proposed correct treatment for each one.
Selection of the independent accountant: Purchase agreements typically designate a specific accounting firm in the agreement itself, often one of the nationally recognized firms, or specify a selection process if the parties cannot agree. The accountant should have no prior relationship with either party. Delays in agreeing on an accountant add cost and extend the resolution timeline, so the agreement should specify a default appointment mechanism if the parties cannot agree within a set period.
The briefing process: Each party submits a written position statement with supporting documentation to the independent accountant within a specified time frame. The accountant may request additional information from either party and typically conducts the review on a documents-only basis without an oral hearing. Some agreements allow for a brief oral presentation; most do not.
The determination: The independent accountant issues a written determination for each disputed item. The determination is limited to the items in dispute and cannot result in a total adjustment outside the range bounded by the buyer's and seller's respective positions. The determination is final and binding, typically non-appealable except in cases of manifest error or fraud.
Fees: The independent accountant's fees are typically allocated between the parties in proportion to the dollar amount of the disputed items each party lost. A party who prevails on all disputed items pays nothing. A party who loses on all disputed items pays the full cost. This cost-shifting structure discourages frivolous disputes on both sides.
The independent accountant process is relatively efficient compared to litigation, but it is not cheap. Disputes involving complex inventory or receivable calculations can generate accounting fees that rival the amount in dispute for smaller transactions. Buyers and sellers who invest in clear methodology drafting upfront spend far less on disputes after closing.
Common Manipulations Buyers Watch For
Sellers who understand how working capital adjustments work may manage the balance sheet in the weeks before closing in ways that inflate reported working capital. These behaviors are not always intentional fraud. Some reflect normal business decisions that happen to benefit the seller. But buyers who recognize them can protect themselves through due diligence, the peg negotiation, and specific representations in the purchase agreement.
Deferring accounts payable: A seller who delays payment to vendors before closing reduces current liabilities and inflates working capital. Buyers should review accounts payable aging as of the closing date and compare it to historical payment patterns. An unusual spike in payables due over 60 or 90 days just before closing is a warning sign. The peg set from historical averages will not capture this deferral.
Accelerating collections: A seller who calls in receivables unusually aggressively before closing may reduce the receivable balance and increase cash. If cash is excluded from working capital, this move does not directly inflate working capital, but it may leave the buyer with a receivable pipeline thinner than what the business normally generates. This affects the buyer's post-closing cash flow even if it does not produce a working capital shortfall at true-up.
Inventory channel stuffing: A seller who purchases excess inventory in the weeks before closing inflates current assets without a corresponding reduction in payables if the purchases are on credit terms that extend beyond the closing date. The buyer inherits inventory it did not model and a payable due shortly after closing. Inventory counts and purchase order review in the final diligence phase help catch this.
Reclassifying long-term assets to current: Some sellers reclassify assets approaching their useful life from long-term to current in the period before closing to inflate current assets. A careful review of asset classifications and their consistency with prior periods is part of the pre-closing financial review process.
Omitting accruals: Sellers who fail to record accrued expenses such as wages, vacation liability, and commissions reduce current liabilities and inflate working capital. A detailed review of accrual completeness compared to prior periods is essential in the closing statement review.
The purchase agreement should include a representation that the closing working capital was prepared using consistent accounting policies applied consistently with prior periods. This representation, if breached, triggers indemnification rights independent of the working capital adjustment mechanism itself. For a full discussion of indemnification in M&A, see the related article on indemnification provisions, caps, and baskets.
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Common Seller Concerns at True-Up
From the seller's perspective, the true-up period is a window of vulnerability. The buyer controls the preparation of the post-closing working capital statement. The seller is no longer running the business. The underlying books and records are in the buyer's hands. Sellers who do not understand the process often discover unexpected shortfall claims months after closing and have limited visibility into how the buyer calculated them.
Buyer overstating reserves: Buyers may apply conservative reserves against receivables or inventory that the seller believes are overstated. The key protection is that the post-closing statement must use the same accounting methodology as the peg, applied consistently. A buyer who changes the reserve methodology post-closing to generate a larger shortfall claim is in breach of the purchase agreement. The seller's objection right exists precisely to challenge this.
Timing cutoff disputes: The purchase agreement specifies an exact closing date and time, but balance sheets do not update instantaneously. Transactions that are in flight at the moment of closing, checks cleared versus outstanding, payables posted but not yet paid, can produce cutoff disputes where both parties have a reasonable basis for their calculation. Clear cutoff rules in the methodology exhibit reduce these disputes.
Post-closing business changes affecting the analysis: If the buyer makes changes to the business in the weeks after closing that affect receivable collections or payable payment patterns, the resulting working capital picture may not reflect the closing-date position. Sellers should ensure that the purchase agreement requires the post-closing statement to reflect the business's financial position at the closing date, not after buyer-driven changes.
Access to books and records: Sellers who find the buyer uncooperative in providing access during the review period are in a difficult position. The purchase agreement should specify that the buyer must provide reasonable access to books and records during the seller's review period. Without this access, the seller cannot verify the buyer's calculation effectively.
How LOIs Memorialize the Peg Methodology
The letter of intent is the first document in the acquisition process where working capital is typically addressed. Most LOIs do not fix the exact peg dollar amount at the LOI stage, because the parties have not yet completed the due diligence necessary to determine what the right number is. But the LOI should establish the methodology that will be used to calculate the peg in the purchase agreement.
A well-drafted LOI working capital provision addresses the following. First, it states that the purchase price is offered on a cash-free, debt-free basis with working capital normalized at a level consistent with ordinary course operations. Second, it identifies the measurement period to be used: trailing twelve months, trailing twenty-four months, or a month-specific calculation. Third, it notes that the parties will agree on a specific peg during the purchase agreement negotiation based on an agreed methodology to be applied to the historical financials.
LOIs that are silent on working capital methodology create negotiating leverage for whichever party has more information about the business's historical working capital patterns. Typically that is the seller. Buyers who do not address methodology in the LOI may find themselves negotiating the peg under time pressure during the purchase agreement phase, when the exclusivity period is running and deal momentum creates pressure to accept the seller's preferred approach.
LOI practice: Even if the specific dollar amount cannot be fixed at LOI, stating "working capital will be delivered at a level consistent with the trailing twelve-month average, calculated using the accounting policies applied in the seller's most recent annual financial statements" gives the buyer a defensible anchor for the peg negotiation and prevents the seller from selecting a low-point calculation period after the LOI is signed.
For a complete treatment of what the LOI should and should not address, see the LOI versus purchase agreement guide. The working capital treatment in the LOI directly shapes how easily or difficultly the purchase agreement negotiation proceeds.
How Quality of Earnings Reports Interact with the Peg
A quality of earnings report (QoE) is primarily used to validate the seller's adjusted earnings figure, the EBITDA or SDE on which the purchase price multiple is applied. But a thorough QoE also addresses the balance sheet and working capital, and this portion of the analysis directly informs where the peg should be set and whether the peg proposed by the seller is defensible.
For working capital purposes, the QoE accomplishes several things. It identifies seasonal patterns in working capital that should inform whether the trailing twelve-month average is an appropriate peg or whether a more sophisticated calculation is needed. A highly seasonal business, such as a retailer or landscaping company, may have working capital that swings by 40 to 60 percent between its peak and trough months. A peg calculated on the trailing twelve-month average may not reflect the working capital needed at the specific month the deal closes.
The QoE also surfaces anomalies in the balance sheet that suggest pre-closing manipulation. A reviewer who sees accounts payable at an unusual low relative to purchases, or receivables at an unusual high relative to revenue, will flag these as items requiring explanation before the peg is finalized. These findings protect the buyer from inheriting a closing balance sheet that diverges from the historical norm used to set the peg.
Working Capital Items a QoE Typically Addresses
- ✓Seasonal working capital patterns and month-by-month analysis for the trailing two to three years
- ✓Receivable aging and collectability assessment, including identification of stale or disputed balances
- ✓Inventory count reconciliation and reserve adequacy review
- ✓Accounts payable timing analysis relative to historical payment patterns
- ✓Completeness of accruals for wages, benefits, and commissions
- ✓Deferred revenue balance and the cost of fulfilling underlying obligations
- ✓Identification of any one-time or non-recurring items that inflate the average used to set the peg
Buyers who skip the QoE on transactions above a moderate size are accepting the seller's working capital narrative without independent verification. In deals where working capital is a large proportion of the total enterprise value, such as distribution, manufacturing, or inventory-intensive service businesses, this is a material risk. The connection between the QoE and working capital peg setting is one of the reasons that understanding valuation metrics and understanding closing mechanics are not separate exercises. They inform each other at every stage of the deal.
Reviewing a Deal with a Working Capital Adjustment?
Acquisition Stars works with buyers and sellers through every stage of the M&A transaction. Alex Lubyansky handles every engagement directly. If you are negotiating a working capital peg, reviewing a post-closing statement, or trying to understand what you are agreeing to in a purchase agreement, the right time to get counsel involved is before you sign.
Frequently Asked Questions
What is a working capital peg?
A working capital peg is the target amount of net working capital the seller must deliver at closing. It is set by negotiation and typically reflects the average working capital level over the trailing twelve to twenty-four months. If the seller delivers more than the peg, the buyer pays extra. If the seller delivers less, the buyer receives a refund. The peg prevents the seller from stripping current assets or deferring current liabilities in the period before closing.
How long is the true-up period?
Most purchase agreements set the true-up window at 60 to 90 days post-closing. The buyer typically has 30 to 60 days to prepare the post-closing working capital statement, and the seller has a review and objection period of 30 days after receiving the statement. If the seller does not object within that window, the buyer's calculation becomes binding. Disputed items go to an independent accountant for resolution.
Can the working capital adjustment change the purchase price significantly?
Yes. In businesses with substantial current assets such as inventory-heavy or receivables-intensive operations, the working capital adjustment can be six or seven figures. A $600,000 shortfall is not unusual in a manufacturing business with a $2 million working capital peg. The adjustment is symmetric: it can increase or decrease the final price. The magnitude depends on how far the actual closing-date working capital deviates from the peg and how large the business's working capital base is relative to enterprise value.
Who calculates the closing working capital?
The seller prepares the estimated closing statement before closing. The buyer prepares the formal post-closing working capital statement after closing, using the agreed methodology. The seller then reviews the buyer's statement and may dispute specific items. If the parties cannot resolve disputes, an independent accountant makes a binding determination on the contested items. The accountant's scope is limited to items formally disputed by the seller in the objection notice.
What if buyer and seller disagree on the calculation?
The seller delivers a written objection identifying each disputed item and the seller's proposed correct amount. The parties have a negotiation period, typically 30 days, to resolve differences. Unresolved items go to an independent accountant who rules on each disputed item within the range of the parties' respective positions. The accountant's determination is final and binding. Fees are allocated in proportion to which party prevailed, discouraging weak disputes.
Is the peg set at LOI or purchase agreement?
The methodology is typically addressed at the LOI stage but the specific dollar amount is fixed in the purchase agreement. LOIs commonly state that working capital will be delivered at a normalized level consistent with historical operations, without stating a number. The purchase agreement then fixes the peg based on an agreed calculation applied to the historical financials reviewed during due diligence. Buyers who do not address methodology in the LOI lose negotiating leverage for the peg negotiation.
Does SBA financing affect how working capital gets handled?
SBA 7(a) loans finance the acquisition of the business, not ongoing working capital. Buyers using SBA financing must ensure the peg is set at a level that provides the business with sufficient working capital to operate post-closing without additional injection. A large true-up shortfall requires out-of-pocket payment that was not part of the original financing structure. SBA lenders also require specific documentation at closing that must be consistent with the working capital treatment in the purchase agreement.
What happens to accounts receivable at closing?
In an asset purchase, accounts receivable are transferred to the buyer and included in the working capital calculation. The seller does not retain the right to collect outstanding receivables unless specifically negotiated. The buyer collects those receivables post-closing and they count toward the working capital delivered at closing. Aged receivables, typically those over 90 days, are often excluded or discounted in the peg calculation to reflect collectability risk. The treatment should be specified in the working capital methodology exhibit attached to the purchase agreement.
Understand the Full Purchase Agreement Framework
Working capital adjustments are one component of a larger set of closing mechanics. Review the complete guides below for context on how they interact.
The working capital true-up is one of several post-closing mechanics that continue after the deal signs. For the full post-closing sequence covering earnout periods, escrow releases, indemnification claims, and TSAs, see our pillar guide: Post-Closing in M&A: Complete Guide.
Related Resources
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