Working Capital Peg in M&A: How It Is Set and Trued Up

What a working capital peg is

When a buyer values a business on a multiple of earnings, the price assumes the business can keep trading normally after completion. That needs a normal amount of working capital: customers owing what they usually owe, enough stock on the shelves, suppliers paid on their usual terms. The working capital peg is the figure both sides agree represents that normal level. It is a target, not a price.

Without a peg, a seller could collect every debtor and run stock down in the weeks before completion, take the cash out, and hand over a business that needs an immediate cash injection to keep trading. The peg prevents that by adjusting the price for the working capital actually delivered.

How the peg is set

The usual starting point is an average of net working capital over a recent period, commonly the last twelve months of monthly balances. Averaging matters because working capital moves through the year: a business that builds stock before a busy season will look very different in September than in January. Setting the peg from a single month-end can hand one side a windfall purely because of when the deal closes.

How the true-up works

Under a completion accounts mechanism, the parties prepare a balance sheet as at the completion date after the deal has closed. Net working capital on that balance sheet is compared with the peg, and the price moves pound for pound by the difference — sometimes only beyond an agreed band, so small differences are ignored. A portion of the price may be held back or placed in escrow until the figure is agreed.

In a locked box deal there is usually no completion true-up. Instead the price is fixed on an earlier balance sheet, and the protection comes from the seller promising there has been no value taken out (leakage) since that date. The working capital in the locked box balance sheet still matters — it is just assessed before signing rather than after completion.

An illustrative example

Where disputes start

• Loose definitions. If the agreement does not list which balances are in and out, the parties will argue over every accrual.
• Different accounting policies. A completion balance sheet prepared with a stricter provision for bad debts than the historic figures will move the price on its own.
• Who prepares the figures. The party preparing the first draft has an advantage; the other needs a clear right and timetable to challenge it.
• No dispute route. Agreements usually name an independent accountant to settle a disagreement. Without one, a working capital argument can become litigation.

Testing the peg in diligence

The peg is only as reliable as the monthly balances it is built from. Annual accounts give one balance sheet a year, which is not enough to see seasonality, so buyers normally ask for monthly management accounts covering at least the reference period. Those figures should be reconciled to the year-end statutory accounts so that the averaging starts from numbers that tie to something independently prepared.

A quality of earnings review usually covers working capital alongside profit, because the two are connected. If revenue has been flattered by generous credit terms, debtor days rise and the business needs more working capital than its history suggests. If suppliers have been paid late to make cash look stronger, creditor days stretch and the normal level is lower than the business can sustain. Either pattern changes what a fair peg is, and both are easier to raise before heads of terms than after.

Buyers should also look at the trend rather than only the average. A business whose net working capital has been falling steadily may be collecting faster, or may be running down stock it will need to rebuild. The average hides which, and the answer changes how much cash the buyer will need to put in during the first year.

The seller's side of the peg

For a seller the peg is about not giving value away twice. If the price already assumes a normal level of working capital, a peg set too high means the seller must leave extra cash in the business or accept a lower price at completion. Sellers therefore argue for a peg that reflects the business as it actually trades, excluding any period of unusual stock build or slow collections, and for a band so that small swings do not trigger an adjustment.

Sellers also benefit from understanding the mechanism early. Running the business normally right up to completion — collecting debts on usual terms, ordering stock as usual — is the simplest way to land close to the peg. Trying to manage the figure in the final weeks tends to be visible in the completion accounts and invites challenge.

Finally, both sides should agree how cash and debt interact with working capital. Most deals are priced on a cash-free, debt-free basis, so cash and borrowings are adjusted separately from the peg. If an item could be argued as either debt or working capital — an overdue supplier balance, a customer deposit, a tax liability — the agreement should place it in one category only, so it is never counted twice or not at all.

How TrueValue helps

TrueValue reads working capital from the target's own filed accounts — debtor, creditor and stock days, the cash conversion cycle and net working capital by year — so the starting point for a peg discussion is the business's own record rather than a guess. After completion, the working capital peg is tracked on the deal's post-close record, with the direction of any adjustment derived once and a disputed true-up recorded as a state with an amount, so it cannot be marked settled while the dispute is still open.