Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The M&A Working Capital Peg That Cost a Seller $6 Million
Transcript
- Lucas: So you're selling your company for $120 million. You've negotiated the multiple, you've shaken hands on the enterprise value. And then, a few months later, you get the closing statement and you walk away with $114 million. You lost $6 million on something you barely discussed during the main negotiation. Luna: And I'm guessing that $6 million didn't go to legal fees or some hidden liability. You're talking about the working capital peg. Lucas: Exactly. The working capital peg. It sounds like accounting boilerplate — and it lives in the back of the definitive agreement, not in the headline term sheet. But it is one of the most common, and most expensive, hidden adjustments in a private company sale. Luna: So let's define it. What is the working capital peg, in plain English? Lucas: In the simplest terms: when you sell a business, the buyer expects to receive a company with a normal amount of working capital. Not too much cash tied up in receivables and inventory, not too little. So they set a target — the peg. At closing, they compare the actual working capital to that target. If it's below, they deduct the difference from the purchase price. If it's above, they add it. At least in theory. Luna: OK, so why would a seller lose $6 million on that? The peg should be based on historical averages, right? Lucas: That's the assumption. And that assumption is exactly what gets sellers into trouble. Let me walk through a real case. A few years ago, a mid-market industrial distributor — let's call them Midwest Supply — was sold to a private equity firm for $120 million. The company had about $30 million in revenue, $10 million in EBITDA. Clean business, steady customers. The buyer proposed a working capital peg of $8 million, based on the company's average working capital over the prior twelve months. The seller's CFO ran the numbers, it looked reasonable, they agreed. Luna: But what was the actual working capital at closing? Lucas: $14 million. Six million above the peg. Now, if the peg was truly the historical average, the seller should have received an extra $6 million on top of the $120 million purchase price. But here's the trap: the buyer had defined the peg using a trailing twelve-month average that included an unusually low period. The company had done a big inventory reduction six months before the sale, temporarily dropping working capital. That low period dragged the average down. Luna: So the peg was set artificially low. And then at closing, working capital had returned to normal levels — actually above normal because of a seasonal spike in receivables — and the buyer used that to claim the company had 'excess' working capital that they didn't want to pay for. Lucas: Exactly. The buyer's argument was: we agreed on $8 million as the normal level. You delivered $14 million. That's $6 million of extra cash that you, the seller, effectively kept by not running the business lean enough. So we're not paying you for it. They capped the adjustment to the downside only — meaning the seller could get docked for low working capital, but couldn't get paid for high working capital. That asymmetry is a killer. Luna: But wait — wouldn't the seller's lawyers catch an asymmetric adjustment like that? A one-way collar? Lucas: You'd hope so. But in this case, the language wasn't explicit. The agreement said the purchase price would be adjusted for any difference between actual and target working capital. Standard language. The trap was in how they defined 'target.' The buyer's definition used a fixed number, $8 million, rather than a formula tied to recent history. And they buried a clause that said any adjustment would be calculated 'consistent with past practices' — which they then interpreted as only allowing deductions, not additions. Luna: So the seller lost $6 million because of a definitional ambiguity. That's brutal. Lucas: It happens more often than you'd think. And the worst part is, the seller's team had focused all their energy on the EBITDA multiple and the earnout. They spent maybe thirty minutes on the working capital peg in the entire negotiation. The buyer's team, meanwhile, had a dedicated working group analyzing twelve months of daily cash conversion cycles. Luna: So what's the lesson for a seller? How do you avoid this? Lucas: First, never agree to a fixed dollar peg without understanding the trailing twelve months in detail. You want the peg to be a formula based on average working capital over the last twelve months, calculated consistently with past practices. And you want that formula to be symmetrical — if actual is above the peg, the seller gets paid. If below, the buyer gets a discount. Luna: And what about seasonal businesses? Midwest Supply had a seasonal spike in receivables at closing. That seems like a predictable problem. Lucas: Absolutely. If you have a seasonal business, the single most important thing you can do is control the closing date. Close in a low working capital period. If you close in December but your business peaks in November, you're handing the buyer a built-in adjustment. Better to close in February after receivables have been collected. Luna: That's smart. So the closing date itself becomes a negotiation point. Lucas: It should be. And here's another concrete step: have your CFO run pro forma working capital calculations for every potential closing date in the next six months. Show the buyer what the adjustment would be under each scenario. That forces transparency. If the buyer insists on a fixed peg, you can price in the risk. Luna: I've also heard that sellers sometimes try to manipulate working capital before closing — like paying down payables or rushing to collect receivables. Does that backfire? Lucas: It can. If you accelerate collections, you boost cash but reduce receivables. Working capital might stay the same. And if the buyer's definition of working capital excludes cash — which it often does — you've just made your working capital look lower. The key is to run the business normally. Don't try to game the number. But do understand what the number is. Luna: Let's talk about the buyer's perspective for a second. Why do buyers push so hard on the working capital peg? Lucas: Because it's one of the few levers they have to adjust the purchase price without renegotiating the multiple. They've already agreed on valuation based on future earnings. The working capital peg lets them protect themselves from a seller who might strip cash out of the business before closing. But the asymmetry I described — that's not protection, that's opportunism. Luna: Quick honest thing — a handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that's literally what funds making this many of these. If these conversations have moved your work forward in some small way, that's the reason we keep going ad-free. Lucas: And we mean it — we don't run sponsorships, we don't sell your data, we just make the show. So if you've gotten value from episodes like this one on working capital traps, that's all the incentive we need. OK, back to it. Luna: So what's the single best piece of advice for a seller entering working capital negotiations? Lucas: Hire a transaction advisory firm that specializes in working capital analysis. Not your regular auditor — someone who's done fifty of these. They'll know the common traps: the exclusion of deferred revenue, the treatment of intercompany balances, the definition of cash equivalents. A good advisor can add millions in value just by refining the peg language. Luna: And it's not just about the peg itself. It's about how you define the components. Do you include prepaid expenses? What about customer deposits? Lucas: Exactly. Every industry has its quirks. For a manufacturer, inventory valuation method matters — LIFO vs. FIFO can swing working capital by millions. For a software company, deferred revenue is the big one. The buyer wants to treat it as a liability that reduces working capital, which means a lower peg. The seller wants to exclude it because it represents future cash. Luna: And what about earnouts? Do they interact with working capital adjustments? Lucas: They can. If you have an earnout based on EBITDA, and the working capital adjustment reduces the purchase price, that's one hit. But then the buyer might also argue that the lower purchase price reduces the earnout base. That's a double whammy. You need to spell out that the earnout is calculated on standalone EBITDA, independent of the working capital adjustment. Luna: So the working capital peg isn't just a closing detail — it ripples through the entire deal economics. Lucas: Exactly. And that's why I always tell founders: spend at least as much time on the working capital section of the purchase agreement as you do on the representations and warranties. It's where the money actually moves. Luna: Alright, so let's recap. For sellers: define the peg as a formula, not a fixed number. Ensure symmetrical adjustments. Control your closing date. And get specialized advisory help. Lucas: And one more: put a working capital true-up mechanism in the agreement with a timeline — say, 60 days post-closing — and a dispute resolution process. That way, if you disagree on the final number, you have a path to resolution that doesn't end in litigation. Luna: Because by then, the buyer has the cash and you have a lawsuit. Lucas: Right. And the best way to avoid that is to negotiate the peg thoroughly before you sign. The working capital peg may not be glamorous, but it's where the rubber meets the road in M&A.