Working Capital Peg and Post-Closing Adjustment in M&A

A working capital peg adjustment is the most common source of post-closing conflict in mergers and acquisitions. The buyer and seller agree on a target for net working capital at closing—the everyday assets and liabilities that fund the business’s operations. When the actual number comes in above or below target, one party owes the other cash to true up the price. Because working capital is hard to predict and easy to manipulate, disputes over these adjustments can linger for years after the deal closes.

What Is Net Working Capital and Why It Gets “Pegged”

Net working capital is the lifeblood of operations: the difference between current assets (accounts receivable, inventory, prepaid expenses, cash) and current liabilities (accounts payable, accrued expenses, short-term debt). A healthy manufacturing business might have $30 million in receivables, $40 million in inventory, $5 million in prepaid costs, and $35 million in payables and accruals, for a net working capital of $40 million.

In a merger or acquisition, the buyer is acquiring not just fixed assets and intangible value, but also the working capital embedded in the day-to-day business. The buyer needs receivables to collect, must manage inventory, and inherits payables to settle. The sale price reflects an assumption about how much working capital will come with the business.

During negotiation, the buyer and seller agree on a “working capital peg”—a target dollar amount. The agreement might read: “The purchase price is $500 million, assuming closing working capital of $40 million. For each $1 million above $40 million, the purchase price increases by $1 million; for each $1 million below, the purchase price decreases by $1 million.”

This peg serves two purposes. First, it allocates risk: if the seller drains working capital from the business before closing (by collecting receivables early and delaying payables), the buyer is compensated. Second, it creates a mechanical adjustment so the buyer does not accidentally overpay for a business that has been depleted of its operational liquidity.

Setting the Peg: Negotiation and Due Diligence

Agreeing on the right peg is harder than it sounds. The buyer and seller must first define what counts as working capital. A typical definition excludes cash and cash equivalents (to avoid double-counting the purchase price adjustment against cash held), excludes long-term debt (which is the seller’s problem to repay), excludes deferred tax assets and liabilities, and sometimes excludes specific items like earnout payables or severance obligations.

The historical working capital level guides the negotiation. The seller provides 12–24 months of historical balance sheets. The buyer calculates the average net working capital over that period—say, $38 million—and proposes that as the peg. The seller might counter with $35 million, arguing the business can be run with lower working capital if inventory is managed tightly.

The buyer conducts due diligence on inventory quality and receivables aging. If 30% of receivables are more than 90 days past due, the buyer argues the historical working capital is inflated and the peg should be lower. If the seller’s season is summer (higher inventory) and closing is in winter (lower inventory), the parties must adjust for seasonality.

Disagreements often surface here. A seller who has historically carried $40 million in inventory to avoid stockouts claims the peg should reflect $40 million; a buyer who sees efficient competitors operating at $30 million argues for a lower peg and threatens to achieve it through supply-chain improvements. These negotiations can delay closing or create resentment if the buyer later claims it achieved lower working capital through careless depletion (underpaying suppliers, clearing receivables at discounts).

The Post-Closing True-Up Calculation

At or shortly after closing, the buyer and seller commission a joint calculation of actual closing working capital. The buyer’s accountants (or an independent firm mutually selected) prepare a detailed analysis:

• Current assets: Itemized receivables, aged by invoice date; inventory valued using the same FIFO, LIFO, or weighted-average method the seller used; prepaid expenses verified to supporting invoices.
• Current liabilities: Itemized payables with vendor approval (or secondary confirmation); accrued wages, utilities, and rent; deferred revenue (if any).
• Net working capital: Assets minus liabilities, excluding agreed-upon items.

The true-up typically occurs 45–90 days after closing, giving the buyer’s team time to conduct a thorough audit. If closing working capital came in at $42 million and the peg was $40 million, the buyer owes the seller $2 million (often adjusted for tax effects, but more on that later). If it came in at $37 million, the seller owes the buyer $3 million.

Most acquisition agreements vest the calculation in the buyer initially: the buyer prepares the closing statement and submits it to the seller for review. The seller has 15–30 days to object, pointing out specific line items it disputes. This is where most conflicts erupt.

Common Sources of Disputes

Inventory Valuation: The buyer and seller may disagree on whether slow-moving inventory should be written down for obsolescence. The seller argues the inventory is still saleable at historical cost; the buyer argues that based on turnover rates and aging, a 10% reserve is justified. In a $40 million inventory base, this disagreement alone can swing the adjustment by $4 million.

Receivables Reserves: If the seller carried a $500,000 allowance for doubtful accounts on $30 million in receivables, and the buyer believes 10 of the receivables will never be collected, the buyer proposes increasing the reserve to $1.5 million. The seller disputes this, claiming the customers are good credits who are simply slow payers.

Accrued Liabilities: The buyer may discover that the seller underaccrued bonuses, utilities, or rent. An understatement of accrued liabilities inflates closing working capital and the buyer owes the seller more than it should. The seller may argue certain accruals belong to the prior period and should not be recognized at closing.

Timing and Cutoff: Transactions on the closing date can be ambiguous. A sale that shipped on closing day but the goods were not yet received—does it count as a closing-date receivable or post-closing revenue? If the seller sent an invoice on closing day for a pre-closing service, does the buyer assume that accounts receivable?

Seasonality: If the seller’s business is seasonal and closing occurred in a seasonal trough (low receivables, low inventory), the buyer claims the working capital is artificially low and the peg was set too high. The seller counters that the peg was based on an average and closing timing is the buyer’s choice.

Escrow and Dispute Resolution

To manage these risks, deals often include an escrow: a portion of the purchase price (typically 10–20% of the purchase price, or a dollar amount like $5 million) is held in escrow for 12–24 months. Working capital adjustments are paid from escrow first; any remaining funds are released to the seller after the dispute window closes.

If the buyer and seller cannot agree on the true-up calculation, the purchase agreement typically specifies an independent accounting firm as arbitrator. The arbitrator reviews both parties’ positions and issues a binding determination. In some high-stakes deals, the arbitrator is instructed to choose one party’s number in full (a “baseball arbitration” format) to discourage unreasonable positions.

Litigation is a last resort, but working capital disputes have spawned multimillion-dollar lawsuits. A buyer who discovers the seller fabricated inventory numbers or withheld accrual information can sue for breach of warranty. A seller who believes the buyer arbitrarily wrote down assets post-closing can sue for bad faith.

Tax Implications of Working Capital Adjustments

The tax treatment of working capital adjustments depends on jurisdiction and deal structure. In the United States, an upward adjustment (buyer owes seller more) increases the seller’s sale proceeds and may create additional capital gains tax liability. A downward adjustment reduces the seller’s proceeds. For the buyer, a downward adjustment (seller owes buyer) may increase the buyer’s basis in the acquired assets (depending on treatment) or reduce the purchase price.

Purchase agreements often include a “grossing up” mechanism: if the working capital adjustment triggers unexpected tax, one party compensates the other. This is negotiated case-by-case and is a source of continued friction if the tax outcome differs from expectations.

Strategies to Minimize Working Capital Disputes

Clear Definition: The agreement must specify exactly what is included in working capital, with examples. “Current assets means cash equivalents, trade receivables aged less than 90 days, and inventory valued using FIFO method, but excludes prepaid expenses and deferred tax assets.”

Reference Balance Sheet: Attach a sample closing balance sheet showing the calculation method, so both parties visualize the same line items.

Tighter True-Up Window: Shortening the post-closing period (from 90 days to 45 days) reduces the seller’s ability to claim the buyer manufactured a low number through operational changes.

Cap and Collar: Instead of dollar-for-dollar adjustment, the agreement can specify a “collar”: if closing working capital is between $39 million and $41 million (a $2 million band around the $40 million peg), no adjustment occurs. Outside the collar, adjustments apply. This protects both parties from small, technical disputes.

Escrow Split: Some deals specify that if escrow is released, it goes 50-50 or in some formula, rather than all to the seller. This incentivizes the seller to agree with the buyer’s calculation and close the loop quickly.

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