Why Working Capital Pegs Matter for Lower Middle Market Sellers

When business owners receive acquisition inquiries, their attention often centers on price. Yet price alone rarely determines what a seller ultimately takes home at closing. Other deal terms, such as when a payment is made, post-closing obligations and price adjustments, can materially affect net proceeds.

Buyers know many sellers focus on headline price or Ebitda multiple and may offer an attractive figure while including terms that quietly reduce value. Sellers must scrutinize these provisions during negotiations.

While some non-price terms — like cash at closing versus seller financing — are obvious, others are more nuanced. One of the most significant is working capital (WC) and related price adjustments. In today’s deal environment, particularly for closely held, owner-operated businesses valued between $5 million and $50 million, WC targets (or the peg) have become a tricky negotiation point that can significantly impact a seller’s net proceeds.

Working Capital: What Is It?

From an accounting perspective, WC is current assets (CA) minus current liabilities (CL) and serves as a measure of a company’s short-term liquidity. While definitions may vary by deal, CA generally include accounts receivable, inventory, prepaids and similar items, though cash on hand is often excluded. CL typically consists of accounts payable, expense accruals and short-term debt. In both cases, “current” generally refers to amounts expected to turn over within 12 months.

In M&A, WC takes on a more practical meaning. Buyers expect the acquired business to be delivered as a true-going concern with sufficient short-term liquidity to operate normally without an immediate cash injection from another source. In other words, buyers do not want to recapitalize the business post-closing or discover that receivables were accelerated or cash stripped out before the sale. Accordingly, purchase agreements typically require the business to be delivered with a normal or customary level of WC at closing.

What constitutes normal or customary, however, is often open to interpretation.

The Working Capital Peg

The WC target, or peg (WCP), is the amount of WC the parties agree must be delivered at closing. Purchase agreements typically allow a post-closing review period during which the buyer determines whether the WCP was met. If the actual WCP exceeds the peg, the seller may receive a positive price adjustment. If the amount was less than the peg, the seller owes the buyer an adjustment through cash, note reduction or similar means.
When WC calculations are not carefully negotiated, these adjustments can reach tens or hundreds of thousands of dollars, even in smaller transactions, and are a frequent source of post-closing disputes. As a result, the WCP has evolved from a technical accounting concept into a key negotiated deal term addressed early in the process.
The parties ultimately negotiate the definitions of CA, CL and the WCP in the purchase agreement. Pegs are commonly based on trailing averages or other methodologies, with the appropriate approach depending on the nature and growth trajectory of the business, but every situation can require unique attention.

WC in Deal Negotiations

Over the past decade, several factors have made WC negotiations more complex and consequential.

Buyers, even in $5 million to $50 million deals, have become more sophisticated and data-driven. Private equity buyers employ accounting firms to analyze earnings quality, cash flow, receivables and inventory practices. These analyses often yield buyer-friendly interpretations of normal working capital, increasing the peg by lowering current assets or increasing current liabilities.

Rising interest rates and tighter credit markets have made post-closing financing challenging, prompting buyers to insist on larger WC cushions at closing. Pandemic-era supply chain disruptions further distorted historical trends, making lookback and averages less reliable and pushing WCP expectations higher.

Finally, many owner-operator businesses manage WC to optimize tax efficiency, rather than M&A readiness, including time collections, payables and inventory purchases. While practical in day-to-day operations, buyers may argue these practices depress WC below what is needed for stable post-closing operations.

For Sellers, Normal Isn’t Always Neutral

For many sellers, particularly those new to WC negotiations, the peg can feel unfair. After all, they’ve operated the business successfully for years, so buyer concerns about WC may seem unwarranted.

Buyers, however, focus less on whether the business can operate at current levels and more on whether it should. Growth plans, stricter credit policies or extended supplier terms may require more liquidity, which buyers often seek to have the seller fund.

This tension can produce big challenges and derail deals, especially when sellers have not fully considered the potential impact of WC adjustments.

Seller Pitfalls

Owner-operators selling for the first time often stumble on WC for a few predictable reasons:

1. Not understanding or foreseeing the WC issue. Many sellers understandably focus on price, Ebitda or valuation multiples. By the time the WC calculation surfaces, the seller may have lost leverage to negotiate the issue effectively.
2. Failing to normalize for business-specific issues. For example, if a WCP is calculated using a 12-month trailing average, but the business has strong seasonality, it may not reflect operational realities.
3. Not excluding non-operating or one-time items. Prepaid expenses, shareholder loans or other one-offs, can distort WC and should be removed or adjusted.
4. Cash issues. Cash is often excluded from CA in the WCP calculation, or the buyer may require a minimum cash balance at closing. Sellers must be clear on how cash is viewed and how It factors into the WCP.

Recommendations For Sellers

Potential sellers can succeed by considering the following:

Consider a sell-side QoE. Just as buyers commission QoE reports, sellers can have accounting advisers prepare a sell-side analysis before going to market. This report should include an estimate of normalized working capital from the seller’s perspective, using defensible assumptions. Buyers will typically not accept a sell-side QoE on its face, but having this analysis helps anchor negotiations and signals sophistication to buyers.

Be careful in the letter of intent. Letters of intent often gloss over working capital with harmless-sounding language like “the business will have a customary level of working capital at closing.” Sellers should consider advocating for more specificity on WC, perhaps even agreeing on the methodology and associated definitions right at the beginning. A well-defined methodology early in the process, including definitions of CA and CL, reduces risks of surprises later.

Model out alternatives. Sellers should work with their professionals to model different possible WC outcomes – best, average and worst cases, and be prepared for what each could mean for the seller’s expected deal proceeds and negotiation strategy.

Carefully manage WC before closing. While sellers should typically avoid manipulating WC (it is often contractually prohibited), they should nonetheless pay careful attention to it while working toward closing with the WCP and its impacts in mind.

WCPs used to be straightforward. Today, they’re more strategic. For potential sellers, the takeaway is clear: understand WC issues before negotiating and appreciate how its nuanced aspects can dramatically impact net takeaway proceeds. Following the guidelines above and working closely with professionals to address WCP as an integral part of deal strategy can prevent costly surprises for sellers at closing.