Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / How the Working Capital Peg Traps M&A Sellers After Close
Transcript
- Lucas: The working capital peg. If you're a founder selling your business, those three words might cost you more than any escrow holdback or earnout cap we've talked about. Luna: And yet most sellers barely even read that clause. They're focused on the headline multiple, not the post-close adjustment formula. Lucas: Right. And the buyer's banker knows that. So here's the scenario. You sell an industrial distribution company — let's call it Midwest Supply — for $45 million. The purchase agreement says net working capital will be pegged at a trailing twelve-month average, calculated as of close. Sounds fair enough. Luna: Except the trailing average was set during a period when the company had unusually high inventory because of supply chain delays. By close, inventory has normalized. Lucas: Exactly. The buyer pegged working capital at $8 million based on that twelve-month average. At close, actual working capital is $6.5 million. That $1.5 million shortfall comes out of the seller's proceeds. It's a dollar for dollar reduction in purchase price. Luna: So the seller effectively subsidises the buyer's working capital for months after close. And they don't even see it coming because they thought the peg was just a technicality. Lucas: Let's walk through the math on a real case. A distribution company I advised — $45 million enterprise value, about $80 million in revenue. The buyer proposed a peg equal to the trailing twelve-month average net working capital, which was $8 million. But the company's business was seasonal: they built inventory in Q3 for the holiday season, then drew it down in Q4. The trailing average happened to catch the peak. Luna: So the peg was artificially high. What did the seller actually have at close? Lucas: At close — which was in February — inventory was at its low point. Accounts receivable were also lower because of post-holiday collections. Actual net working capital was $6.2 million. The buyer applied a $1.8 million purchase price adjustment. Luna: That is brutal. So the seller got $43.2 million instead of $45 million, all because of a formula they barely debated. Lucas: And here's the killer: the buyer's definition of 'net working capital' excluded cash and debt, but included all trade receivables and payables. The seller had a $500,000 tax receivable from a prior year refund. The buyer argued it wasn't 'current' in the ordinary course, so it got excluded. Another $500,000 hit. Luna: So the total clawback was $2.3 million on a $45 million deal. That's over 5 percent. That's worse than most escrow holdbacks we've covered. Lucas: And escrow is at least capped. Working capital adjustments are uncapped — it's a true-up. If actual is $2 million below the peg, the seller loses $2 million. No negotiation. Luna: So what's the alternative? How does a seller protect themselves? Lucas: First, negotiate the peg definition before you sign the letter of intent. Don't accept a trailing twelve-month average unless your business is perfectly linear. Better to use a trailing three-month average or, even better, a fixed-dollar amount based on a recent balance sheet date. Luna: A fixed peg means both sides agree on a specific working capital target, say $6.5 million, with a collar of plus or minus $500,000. That's much cleaner. Lucas: Exactly. And second, watch the components. Make sure the definition of net working capital is consistent with how you've run the business. Exclude non-operating items like tax receivables, related-party receivables, or prepaid expenses that don't recur. Luna: You also want to limit the adjustment to a two-way peg — meaning if actual is above the peg, the buyer pays the seller extra. But many buyers try to make it one-way, where the seller can only lose. Lucas: That's a red flag. A one-way peg is basically a price cut disguised as a working capital clause. I've seen buyers argue that 'working capital should revert to normal,' but normal always means lower. They never say it could be higher. Luna: So the seller needs an impartial third-party auditor to resolve disputes. That's standard in most purchase agreements for the escrow release, but many sellers forget to apply it to working capital adjustments. Lucas: Right. The typical process: the buyer prepares a closing statement within 60 to 90 days. The seller has 30 days to object. If they can't agree, an independent accounting firm — often the seller's own auditor — makes the final determination. But the seller has to explicitly write that into the agreement. Luna: And what about timing? We've seen deals where the buyer takes six months to produce the closing statement, by which point the seller's team has disbanded. Lucas: That's a deliberate tactic. By the time the adjustment comes, the seller's CFO is already at a new job, the data room is gone, and the seller just wants to close out. So you put a hard 45-day deadline on the buyer to deliver the closing statement. Luna: Let's talk about the other side too. From the buyer's perspective, the working capital peg is meant to ensure they don't overpay for a business that's been stripped of cash or inventory. It's not inherently malicious. Lucas: No, it's a legitimate protection. If a seller deliberately draws down receivables before close, the buyer shouldn't inherit a working capital deficit. The problem is when the peg is set using a formula that doesn't reflect the business's true operating needs. Luna: So what's a fair middle ground? I've seen deals where the peg is based on the trailing twelve-month average, but with an adjustment for seasonality — like using a weighted average that gives more weight to recent months. Lucas: That works. Or you could peg to the average of the last three month-ends, which is harder to manipulate. Another approach: set the peg as a fixed dollar amount, say $7 million, and then agree on a working capital target range of plus or minus 10 percent. Anything outside that range triggers an adjustment. That gives both sides predictability. Luna: You also see deals where the working capital adjustment is capped at, say, 2 percent of the purchase price. That's effectively a compromise between an uncapped true-up and a fixed peg. Lucas: But the cap has to be symmetrical. If the buyer only caps the downside for the seller, that's not a compromise. I've had buyers propose a $500,000 cap on the seller's downside but no cap on the upside if working capital is higher — which never happens. That's just theater. Luna: Let's bring in a concrete example from the podcast's wheelhouse. We talked about the escrow holdback trap in episode 60. How does the working capital peg compare in terms of actual dollar exposure? Lucas: In that episode, the typical escrow was 10 percent of the purchase price, held for 12 to 18 months, with a negotiated release schedule. Here, the working capital adjustment can be uncapped and hits immediately. In the Midwest Supply case, the hit was 5 percent of the deal value — equivalent to half the typical escrow — but it happened within 90 days of close, with no opportunity to earn it back. Luna: And unlike earnouts, which at least give the seller a chance to hit targets, the working capital adjustment is purely retrospective. The seller has no control over it after signing. Lucas: That's the critical point. Once the deal closes, the seller has no operational control. If the buyer changes payment terms with customers and slows receivables, that hurts the seller's working capital position. But the seller can't do anything about it. Luna: Which is why the seller's best leverage is in the negotiation of the peg — before signing. After that, it's in the buyer's hands. Lucas: One more wrinkle: in asset sales, working capital often includes inventory that's valued at cost. If the buyer's accounting policy is LIFO and the seller used FIFO, there can be a huge discrepancy in the inventory valuation. That's another trap. Luna: So the seller needs to audit the buyer's proposed accounting methodology before signing. And get it in writing in the purchase agreement. Lucas: Absolutely. The working capital peg is one of those clauses that looks like a technicality but can move the needle by millions. Sellers should spend as much time on it as they do on the earnout. Luna: You know, this kind of real-world negotiation insight is exactly why I love working on this podcast. And it's also why a lot of listeners tell us they've saved themselves real money from these episodes. Lucas: That's the best feedback we get. If these conversations have moved your work forward in some small way — maybe helped you negotiate a better deal term or avoid a pitfall — that's what keeps us going. Luna: And a couple of dollars a month is genuinely what keeps these going — buy me a coffee dot com slash fexingo, if you've gotten something out of them. Lucas: No pressure ever. We just love doing this. Okay, back to the working capital peg. Let's talk about one more real-world case I saw recently. Luna: Please, I want to hear how a smaller deal handled it. Lucas: A $12 million IT services company. The buyer wanted a peg based on 15 percent of trailing revenue, which was about $1.8 million. But the company had just signed a big contract that required a $400,000 prepayment from the customer — which was a current liability under GAAP. That liability reduced net working capital. Luna: So the seller's actual net working capital was only $1.4 million, triggering a $400,000 adjustment. On a $12 million deal, that's 3.3 percent. Lucas: Right. And the seller hadn't thought about how deferred revenue or customer prepayments would be treated. The buyer's definition of 'current liabilities' included all deferred revenue, even though the cash was already in the bank. The seller effectively paid the buyer for the privilege of having collected cash in advance. Luna: So the lesson is: if your business has significant deferred revenue or prepaid expenses, you need to carve those out of the working capital definition. Or at least negotiate a different peg. Lucas: Yes. You can define net working capital as current assets minus current liabilities, excluding deferred revenue, income taxes payable, and any short-term debt. That's a common carve-out. Luna: And what about the timing of the closing statement? I've seen buyers use a 'closing date' that's 30 days after actual close, which gives them time to cook the books. Lucas: That's another trap. The closing statement should be based on the actual closing date's balance sheet. If the buyer wants to use a subsequent month-end, they need to adjust for intervening transactions. But that's a can of worms. Best to stick with the closing date. Luna: So to summarize for sellers: know what your normal working capital is. Negotiate the peg based on a recent actual balance sheet, not a trailing average. Define the components clearly. Include a dispute resolution mechanism with an independent auditor. And cap the adjustment if you can. Lucas: And get it all in the letter of intent. Once you're in the purchase agreement, the buyer's lawyers have already baked in their preferred language. The LOI is where you have leverage. Luna: This episode should save someone a lot of money. Next time, maybe we'll talk about the tax indemnity trap in asset sales. That's another one that sneaks up on sellers. Lucas: Good call. Until then, take a close look at that working capital peg in your next deal.