Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Working Capital Peg That Cost a Seller 2 Million
Transcript
- Lucas: You're in a deal room. You've spent nine months negotiating the purchase price. You shake hands on $40 million. Then, buried in the definitive agreement, there's a number called the working capital peg. And if you don't understand it, that $40 million can shrink by $2 million before you even leave the building. Luna: And this isn't a hypothetical. You're talking about that manufacturing deal we looked at last week — the one where the seller walked away thinking he got full price. Lucas: Exactly. I'm talking about a real mid-market deal that closed in late 2025. A precision-components manufacturer — let's call it Midwest Machining — sold to a private equity-backed strategic buyer for $40 million. It looked clean. But the working capital peg was set at $8 million based on a balance sheet from April. The deal closed in October. By then, the company had built up inventory for a big customer order. Actual working capital at closing was $10.2 million. The buyer said, 'Congratulations — you're $2.2 million over the peg. We're keeping that as a reduction to the purchase price.' Luna: Wait — so the buyer got to keep the extra working capital? That sounds like the seller funded the company's growth and then got penalized for it. Lucas: That's exactly what happened. And the seller's attorney had approved the peg. But the seller hadn't realized that the working capital target was based on a historical snapshot, not a forward-looking average. The buyer had negotiated a fixed peg, not a rolling peg tied to the trailing twelve months. That's the difference between walking away with $40 million and walking away with $37.8 million. Luna: So for someone who's not an accountant — what is a working capital peg, actually? And why does it matter more than the purchase price in some deals? Lucas: Great question. In M&A, working capital is defined as current assets minus current liabilities — basically, the cash the business needs to operate day to day. The working capital peg is a dollar amount that the buyer and seller agree represents the 'normal' level of working capital the business should have at closing. If actual working capital at closing is above the peg, the seller gets a dollar for dollar increase in the purchase price. If it's below, the buyer deducts the shortfall. The problem is, the peg is often set months before closing, and the business keeps running. If you build inventory, if you collect receivables slower, if you pay payables faster — all of that changes your working capital. And if you haven't negotiated a mechanism to adjust the peg, you're at the buyer's mercy. Luna: And in that Midwest Machining case, the buyer specifically designed the timing of the peg to capture that inventory buildup, didn't they? Lucas: They did. The buyer's due diligence team noticed that the company had a seasonal inventory ramp in Q4. So they set the peg based on a low-working-capital month — April — knowing that October would have higher inventory. The seller's team didn't push back because they were focused on the $40 million headline. They treated the working capital section as boilerplate. That's a $2.2 million mistake. Luna: And honestly, if a conversation like this has ever saved you from a costly mistake — or just made you think differently about a deal — it feels worth mentioning that listener support is what keeps this show free and ad-free. If today's episode was worth a coffee, you know where to find us: buy me a coffee dot com slash fexingo. Lucas: Yeah, it's a small gesture that goes a long way in keeping the production independent. Now, back to that working capital trap — there's a second way the peg can cost you, and it's even sneakier. It's called 'normalized net working capital.' Luna: Define that for us. Lucas: Most sellers assume working capital is just the balance sheet number. But buyers almost always negotiate a 'normalized' definition — which excludes cash, excludes debt, and sometimes excludes certain receivables or payables. The idea is to capture only the operating components: accounts receivable, inventory, and accounts payable. But the buyer gets to define what's 'normal.' In one deal I saw, the buyer excluded all receivables over 90 days old from the working capital calculation — which effectively meant the seller had to collect those before closing, or lose the value. That cut the effective purchase price by another $400,000. Luna: So the definition itself becomes a weapon. And the seller — who's usually a founder or operator, not a finance expert — doesn't realize they're giving away negotiating leverage. Lucas: Right. And there's a third trap: the working capital true-up mechanics. Some agreements don't let you settle the adjustment until 90 days after closing, and the buyer holds the money in escrow. Meanwhile, the buyer's accounting team can interpret the definition in ways that minimize the seller's payout. I've seen buyers reclassify prepaid expenses as non-operating, or argue that a routine supplier payment should be treated as a liability that reduces working capital. By the time the seller's team reviews the final calculation, the 90-day window for disputing it has passed. Luna: So what's the smart seller's play? How do you protect yourself? Lucas: Three things. First, negotiate a rolling working capital peg — based on the trailing twelve months' average, not a single historical snapshot. That smooths out seasonality and inventory fluctuations. Second, agree on a detailed definition of normalized net working capital upfront, with specific line items included and excluded. Attach a sample calculation in the letter of intent. Third, negotiate a shorter true-up period — 30 days, not 90 — and require that any disputes go to a neutral third-party accountant whose decision is binding. Also, if you're the seller, track your working capital weekly between signing and closing. Don't let the buyer be the only one with real-time data. Luna: That last point is huge. In the Midwest Machining case, the seller could have seen the inventory building and either slowed purchasing or negotiated a pre-closing dividend to pull the excess cash out. Lucas: Exactly. If the seller had taken a $2.2 million dividend before closing, the working capital would have been back down to the peg, and the buyer couldn't have claimed the deduction. But because the seller wasn't tracking it, they didn't see the trap until it was too late. Luna: And I imagine this is even more dangerous in deals with earnouts — because the working capital peg can interact with the earnout calculation in ways that compound the seller's loss. Lucas: That's a whole other layer. If the earnout is based on EBITDA, and the buyer uses working capital adjustments to shift expenses into the earnout period, the seller can get hit twice — once on the purchase price and once on the earnout. I've seen cases where a seemingly small working capital dispute wiped out 30 percent of the earnout. Luna: So for anyone listening who's thinking about selling their business, what's the one number they should look at first in their LOI? Lucas: The working capital target. Not the purchase price. Read the definition, look at the reference period, and ask your advisor to model three scenarios: what if inventory is 10 percent higher at closing? What if receivables slow by 15 days? What if payables are paid faster? Then you'll see the real range of outcomes. If the purchase price is $40 million but the working capital adjustment could swing $3 million either way, the headline number is almost meaningless. Luna: And that's the real lesson. In M&A, the details aren't just details — they're the deal. Thanks, Lucas. That's a sobering but essential look at the working capital peg. Lucas: Thanks, Luna. If you're preparing for an exit, spend an extra hour on the working capital section. It might be the most profitable hour of your life.