Quick answer: Net working capital is a business’s short-term operating assets, mainly receivables and inventory, minus its short-term operating liabilities, mainly payables and accrued expenses. In a sale, buyer and seller agree on a target level called the peg, the amount the business needs to operate normally. If working capital at closing falls short of the peg, the price is reduced, and if it exceeds the peg, the price increases.
Key points
- The peg protects the buyer from receiving a business stripped of the working capital it needs, and it protects the seller from giving away more than the price assumed.
- Most pegs are based on an average of recent monthly working capital, adjusted for seasonality, unusual items and growth.
- What counts as working capital is negotiated. Cash and debt are excluded, and items such as customer deposits and accrued bonuses are common points of dispute.
- A small difference in the peg can change proceeds by as much as a difference in the headline price, so the definition deserves the same attention as the price.
What working capital is
Every operating business needs money tied up in the day-to-day cycle of buying, producing, selling and collecting. A company that sells on credit has receivables that will turn into cash. A manufacturer holds inventory. At the same time, the company owes suppliers and employees for things it has used but not paid for yet. Net working capital is the balance of those items.
In a deal, net working capital usually equals current operating assets minus current operating liabilities, excluding cash and debt. The typical components are listed below.
| Typically included | Typically excluded |
|---|---|
| Accounts receivable | Cash and cash equivalents |
| Inventory | Interest-bearing debt |
| Prepaid expenses | Income taxes payable and deferred taxes |
| Accounts payable | Transaction expenses |
| Accrued expenses | Other items the parties treat as debt-like |
Customer deposits, deferred revenue and accrued bonuses are frequent subjects of negotiation. They can sit inside working capital or be treated as debt-like, and the choice changes who bears the cost.
Why there is a peg
A buyer pricing a business assumes it will receive the company with a normal level of working capital, enough to operate without injecting cash on day one. If the seller could collect every receivable and delay every payable before closing, the buyer would receive a business that needed funding the price did not contemplate.
The peg fixes this. It is a target level of net working capital that the parties consider normal for the business. At closing, the actual working capital is compared with the peg. A shortfall reduces the price dollar for dollar, and an excess increases it. The seller is therefore indifferent to timing games, and the buyer is protected from an empty business. The bridge from enterprise value to equity value shows where this adjustment fits in the calculation of proceeds.
How the peg is set
The method most buyers and sellers start from is the average of net working capital over a recent period, often the trailing twelve months, calculated from monthly balance sheets. An average smooths out the swings that happen as invoices are issued and paid.
The average is then adjusted for features of the business.
- Seasonality. If the business has a peak season, the level of working capital at the closing date may be much higher or lower than the average. The parties may use an average for the same season, or a seasonal schedule.
- Unusual items. One-time events, such as a very large customer order or a disputed receivable, are removed so that the peg reflects the normal course.
- Growth. A growing business needs more working capital than it did last year. A seller argues for a peg based on historic levels, while a buyer argues for one that reflects the larger business it is acquiring.
- Accounting consistency. The calculation should use the same policies that produced the financial statements the price was based on. Changing policies can move the peg and the closing figure in opposite directions.
Illustrative example: How the adjustment works at closing
The parties agree on a peg of $4,100,000. At closing, the estimate of delivered net working capital is $3,800,000, which is $300,000 below the peg, so the closing payment is reduced by $300,000. If the business delivered $4,300,000, the closing payment would rise by $200,000. After the books are closed, the final figure is calculated and any difference from the estimate is settled between the parties. The numbers are invented to show the mechanics and are not a benchmark.
The points most often disputed
Disagreements about working capital tend to cluster in a few areas.
Which accounts are included. Buyers prefer a narrow definition that treats ambiguous liabilities as debt. Sellers prefer a broad definition that keeps normal operating accruals inside working capital. The debt-like items list in the bridge guide shows the usual candidates.
Reserves. The allowance for doubtful receivables and the reserve for slow-moving inventory directly change the figure. Buyers will test whether the reserves are adequate, and sellers should be ready to defend them.
Aged receivables and inventory. Old receivables that are unlikely to be collected, and inventory that will not sell at book value, reduce real working capital even if the books carry them at full value. The quality of earnings review typically tests both.
Estimates and accruals. Items that depend on judgment, such as accrued bonuses, warranty reserves and vacation, are a common source of friction. Settling the approach before the letter of intent reduces disagreements later.
What sellers can do in advance
- Know your own working capital. Calculate it monthly for several years. A seller who has the numbers is better placed to argue for a peg that reflects the business.
- Understand the seasonal pattern. If the closing date will fall at a high or low point, address it before it becomes a surprise.
- Keep payment practices consistent. Changing how fast you collect or pay in the months before a sale will be noticed and can be reversed in the adjustment.
- Clean up receivables and inventory. Writing off what will not be collected, or selling slow stock, before the buyer’s review avoids disputes later.
- Agree on definitions early. The peg should be addressed in the letter of intent, not left to the purchase agreement. The letter of intent guide lists this among the terms to review.
Why it deserves attention
Owners sometimes treat the working capital adjustment as an accounting detail. It is not. A peg set too high shifts value from seller to buyer even if the headline price is unchanged, and a loosely defined one invites a dispute after closing. The seller’s due diligence checklist lists the working capital records buyers request, and the overview of transactional valuation explains how a valuation carries the analysis through to the amount an owner receives.
Frequently asked questions
Is working capital the same as cash?
No. Cash is excluded from net working capital in most deals because it is handled separately in the cash-free, debt-free price. Working capital here means operating items such as receivables, inventory, prepaid expenses, payables and accruals.
How is the peg usually calculated?
Commonly as an average of net working capital over a recent period, often the trailing twelve months, using monthly balance sheets. Buyers and sellers then adjust the average for seasonality, one-time items and the direction of growth. The method is a matter of negotiation.
Can the seller reduce working capital before closing to take cash out?
Not without consequence. Collecting receivables faster or delaying payables lowers working capital, and the peg adjustment then reduces the price by the shortfall. Buyers watch for changes in payment patterns in the months before closing.
What happens if the estimate at closing turns out wrong?
Most agreements use an estimate at closing followed by a true-up after the books are closed. If the final figure differs from the estimate, one side pays the other. Disputes usually go to an independent accountant under a process set out in the agreement.
Need a valuation you can use in a sale or acquisition decision?
The Impetus Group prepares transactional valuations from the standpoint of strategic and financial buyers. A valuation is a standalone engagement with its own scope and fee, and it can be the first step before a sale or acquisition process.
Related guides
- From Enterprise Value to Equity Value: What the Owner Receives: Enterprise value is the price of the business. Equity value is what owners receive after debt, debt-like items, cash and working capital. See the bridge.
- Quality of Earnings Report: What It Is and What Buyers Test: A quality of earnings report tests whether a company’s reported profit is real and repeatable. See what buyers examine, how it affects price and how sellers prepare.
- How to Read a Letter of Intent: The Terms That Decide What You Receive: A plain-language guide to the letter of intent in a business sale: price, structure, working capital, exclusivity, diligence and the terms that move your proceeds.
- Due Diligence Checklist for Sellers: What Buyers Ask For and Why: A checklist of the documents and answers buyers request in diligence on a company sale, grouped by area, with the reason each request is made.
- Transactional Valuation: What It Is and How It Works: A transactional valuation estimates what a strategic or financial buyer would pay for a business. Learn what goes into one and how it differs from an appraisal.
- EBITDA Add-Backs: What Buyers Accept and What They Reject: Learn which EBITDA add-backs buyers accept in a sale, which they reject, and how adjusted EBITDA changes enterprise value, with a worked illustration.
This guide is general education. It is not a valuation opinion, appraisal, investment advice, or legal or tax advice. How these guides are made.