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Working Capital Peg in M&A: How to Set It and Defend It

The working capital peg in M&A determines the purchase price adjustment at closing. Getting the methodology and normalization right protects both sides.

Datapack Team

Working Capital Peg in M&A: How to Set It and Defend It

The working capital peg is the agreed-upon level of net working capital that the target company is expected to deliver at closing. If actual NWC at closing exceeds the peg, the buyer pays more. If it falls short, the buyer pays less. The difference flows through the completion accounts mechanism as a dollar-for-dollar purchase price adjustment.

For Transaction Services teams, the NWC peg is one of the most consequential numbers in the deal. A peg set too high benefits the seller. A peg set too low benefits the buyer. Both sides have an incentive to push it in their direction, and the TS team must provide a defensible recommendation.

How the Peg Works

The standard M&A purchase agreement includes a target working capital amount, the peg. At closing, actual NWC is measured using an agreed-upon methodology. The difference between actual and target generates a price adjustment.

Example:

  • Working capital peg: $5.0 million
  • Actual NWC at closing: $4.2 million
  • Purchase price adjustment: -$0.8 million (buyer pays less)

The mechanics are simple. The complexity lies in three areas: defining what is included in NWC, normalizing the historical data, and selecting the peg methodology.

Defining NWC Components

The first negotiation is scope: which accounts are included in the working capital calculation?

Standard inclusions:

  • Trade receivables
  • Inventory
  • Prepaid expenses (operating)
  • Trade payables
  • Accrued liabilities (operating)
  • Deferred revenue (in some deals)

Standard exclusions:

  • Cash and cash equivalents (part of net debt bridge)
  • Short-term debt (part of net debt)
  • Tax receivables and payables (typically net debt or separate items)
  • Intercompany balances
  • Non-operating accruals

The boundary between NWC and net debt matters. An item included in NWC affects the peg calculation. The same item in net debt affects a different part of the price bridge.

For Transaction Services teams, getting this classification right depends on accurate chart of accounts mapping and careful review of the target's balance sheet structure. Misclassified accounts can shift the peg by material amounts.

Normalizing Historical NWC

Raw historical NWC is rarely suitable for peg determination. Common normalizations include:

One-time items: Unusual receivable balances (a single large disputed invoice), abnormal inventory buildups (pre-launch stocking), or catch-up accruals that distort the monthly pattern.

Seasonal patterns: Businesses with seasonal revenue or purchasing cycles show NWC that varies significantly by month. A retailer's December NWC looks nothing like its July NWC. The peg must account for this.

Accounting changes: If the target changed its accrual methodology or revenue recognition policy during the analysis period, historical NWC may not be comparable across periods.

Related-party effects: Intercompany receivables or payables that are expected to be settled at closing should be excluded from the normalized analysis.

Each normalization should be documented with the same rigor as a QoE adjustment, including source data references and quantified impact.

Peg Methodologies

Trailing Average

The most common approach. Typically calculated as the average of trailing 12 months of normalized NWC. Pros: smooths seasonality and month-to-month volatility. Cons: may include non-representative periods.

Variations include trailing 6-month, trailing 24-month, or trailing 12-month excluding specific outlier months.

Seasonal Match

Used when the business has strong seasonality and closing is expected in a specific seasonal period. The peg is based on the same month or quarter from prior years.

Example: If closing is expected in June, the peg is based on the average of June NWC from the last 2 to 3 years. This avoids the distortion that occurs when a December-heavy retailer closes in June with a peg based on annual averages.

Run-Rate

For businesses undergoing structural change (rapid growth, shift in business model, acquisition integration), historical averages may not be representative. The peg is set based on recent run-rate NWC, often the trailing 3 months, adjusted for known changes.

Sensitivity Analysis

A defensible peg recommendation includes sensitivity analysis showing how the peg changes under different methodologies and normalization assumptions.

If the peg ranges from $4.5M to $5.5M depending on methodology, that $1.0M spread is a direct purchase price variable. Both sides need to understand the drivers of this range.

The NWC analysis workstream should present the peg under multiple scenarios, with a recommended methodology and clear rationale.

Common Disputes

Working capital disputes are among the most frequent post-closing disagreements. Common areas of contention:

  • Definition of NWC accounts: Items the buyer considers debt-like, the seller considers working capital.
  • Normalization disagreements: Whether specific items should be normalized out of the historical calculation.
  • Methodology selection: Which trailing period produces the most representative peg.
  • Closing date management: Sellers may manage NWC upward approaching closing to minimize the adjustment.

Clear documentation, including complete audit trails from source data to peg calculation, reduces dispute risk. When both sides can verify every number, disagreements focus on methodology rather than arithmetic.

TS Team Considerations

For Transaction Services teams, the NWC peg workstream requires:

  1. Clean monthly data: 24 to 36 months of monthly balance sheet data, properly mapped and normalized.
  2. Accurate mapping: Every balance sheet account classified correctly as NWC or non-NWC. Even one misclassified account can shift the peg.
  3. Multiple methodologies: Present the peg under different approaches so the client can make an informed decision.
  4. Clear documentation: Every normalization and its impact, traceable to source data.

Teams that automate the data preparation for NWC analysis, from data normalization to monthly bridge construction, deliver this workstream faster and with fewer errors. The analytical judgment in selecting the methodology and determining normalizations remains manual. Everything else can be streamlined.