In mergers and acquisitions (M&A), the signing price is rarely final. One key adjustment is working capital — the difference between current assets and current liabilities. It sets the liquidity a business needs to run smoothly and avoids cash surprises. This guide shows how to set the peg (target level), agree on bands (range), and write it into the Share Purchase Agreement (SPA).

 

What is working capital adjustment? When one company buys another (M&A), the price isn’t always final at signing. A working capital adjustment is a way to check the business has enough short-term money (cash, inventory, receivables) to keep running after the deal closes. If the actual working capital at closing is higher or lower than the agreed “normal” amount (the peg), the purchase price is adjusted up or down to make it fair.

 

Key Takeaways

 

  • Purpose: A working capital adjustment protects the buyer by ensuring the business has enough liquidity at closing to operate without an immediate cash injection.
  • Mechanism: The final purchase price is adjusted post-closing by comparing actual net working capital (NWC) with a pre-agreed target (the “peg”).
  • Outcomes: If actual NWC > peg, the buyer pays the seller the excess; if NWC < peg, the seller reimburses the buyer.
  • Components of NWC: Typically includes operating assets (accounts receivable, inventory) and operating liabilities (accounts payable, accrued expenses). Excludes cash, debt, and transaction costs.
  • Setting the Peg: Calculated using 12–24 months of normalized historical data, with adjustments for seasonality, growth, and unusual items.
  • Negotiation Factor: Peg-setting is both analytical and strategic—buyers push for higher liquidity, sellers for lower, with definitions in the SPA being critical.
  • Adjustment Formula: Purchase Price Adjustment = Actual Closing NWC – Target NWC (Peg).
  • SPA Clauses: Must clearly define calculation principles, timelines, review periods, dispute resolution, and tolerance bands (“collars”) to avoid conflict.
  • Completion Accounts vs. Locked Box: Completion accounts adjust the price post-closing; locked box fixes the price pre-signing, shifting interim risk to the buyer.
  • Common Disputes: Often arise from misclassification of items, inconsistent accounting policies, and treatment of deferred revenue.
  • Risk of Manipulation: Sellers may attempt “window dressing” (e.g., delaying payables, accelerating receivables). Strong QoE analysis helps detect this.
  • QoE Reports: Essential for buyers to support peg negotiations and for sellers to defend their position with credible analysis.

 

 

 The Core Objective of the Working Capital Adjustment

 

At its core, a working capital adjustment is there to protect the buyer in an M&A deal. When someone buys a business, they expect it to keep running normally from day one — paying bills, collecting receivables, and funding operations — without the buyer needing to inject extra cash immediately.

To make sure of this, the buyer and seller agree on a “normal” level of net working capital (NWC) that the business should have at closing. This agreed amount is called the peg.

The mechanism works like a balance check:

  • If the actual NWC at closing is higher than the peg, the buyer pays the seller the difference.
  • If the actual NWC is lower than the peg, the seller reimburses the buyer, which reduces the final purchase price.

This adjustment isn’t meant to change the company’s valuation — it’s a value-neutral safeguard. Its only purpose is to ensure the business is delivered on a cash-free, debt-free basis with a fair, “normal” level of day-to-day liquidity.

 

 

 Key Components of Net Working Capital (NWC)

 

Defining what constitutes NWC is a critical step in any M&A negotiation. The definition must be explicitly detailed in the SPA to avoid ambiguity. While based on standard accounting principles, the precise components are deal-specific.

 Typical Inclusions (Operating Assets & Liabilities)

  • Current Operating Assets: These are assets directly tied to the company’s core revenue-generating activities. The most common examples are Accounts Receivable (trade debtors) and Inventory.
  • Current Operating Liabilities: These are liabilities incurred in the normal course of business operations. Key examples include Accounts Payable (trade creditors) and Accrued Expenses (e.g., salaries, utilities, rent payable).

 Typical Exclusions (Non-Operating & Financing Items)

  • Cash and Cash Equivalents: In a “cash-free, debt-free” deal, the seller retains all cash, so it is excluded from the NWC calculation.
  • Debt and Debt-Like Items: All short-term and long-term debt is excluded as it is typically paid off by the seller at closing or accounted for separately in the enterprise-to-equity value bridge.
  • Transaction-Related Expenses: Costs related to the deal itself (e.g., banker fees, legal fees) are typically excluded.
  • Deferred Tax Assets/Liabilities: These are non current items and generally considered non-operating and are excluded from the NWC calculation.

 

 How to Calculate the Working Capital Peg

 

The working capital peg (or target) is the negotiated, normalized level of NWC that the seller is required to deliver at closing. Setting this peg is one of the most negotiated aspects of the adjustment. The goal is to establish a baseline that represents the true, ongoing operational liquidity needs of the business, smoothing out any unusual fluctuations.

 Step 1: Historical Data Analysis & Normalization

The process begins by analyzing the target’s historical monthly balance sheets, typically for the last 12 to 24 months. This data must be “normalized” to create a fair baseline. Normalization adjustments remove the impact of any non-recurring, non-operating, or unusual items. Common adjustments include:

  • Removing one-off bad debt write-offs.
  • Adjusting for unusual inventory build-ups or drawdowns.
  • Correcting for non-standard bonus accruals.
  • Reclassifying items that should be treated as debt-like rather than working capital.

 Step 2: Selecting an Averaging Methodology

Once the historical data is normalized, the parties must agree on a methodology to calculate the average NWC level. The choice depends on the nature of the business.

  • Trailing Twelve-Month (TTM) Average: The most common method, providing a representative view of the business over a full operating cycle.
  • Seasonal Average: For businesses with significant seasonality (e.g., retail, agriculture), a TTM average might be misleading. It may be more appropriate to use an average that reflects the NWC level at the specific time of year the closing is expected to occur.
  • Fixed Peg: In some cases, parties may simply negotiate a fixed dollar amount for the peg based on their respective analyses and due diligence findings.

 Step 3: Projecting for Growth and Future Changes

A purely historical average may not be sufficient for a rapidly growing business. If the company’s revenue is projected to increase significantly, its working capital needs will also grow. In such cases, the peg may be adjusted upward based on a formula, such as a percentage of projected future revenue, to ensure the business is adequately capitalized for its post-closing growth trajectory.

 

The Net Working Capital Adjustment Formula

 

The mechanics of the adjustment are straightforward. The calculation is performed after closing once the final closing balance sheet is prepared and audited. The formula is as follows:

Purchase Price Adjustment = Actual Closing Net Working Capital – Target Net Working Capital (Peg)

The outcome determines who pays whom:

  • If Actual NWC > NWC Peg, there is a surplus. The buyer pays the seller the difference, increasing the total proceeds received by the seller.
  • If Actual NWC < NWC Peg, there is a deficit. The seller pays the buyer the difference (or it is deducted from an escrow account), reducing the total proceeds for the seller.

 Illustrative Example:

  • Negotiated NWC Peg: $2,000,000
  • Actual NWC at Closing (determined post-closing): $1,850,000
  • Calculation: $1,850,000 – $2,000,000 = -$150,000
  • Result: There is a $150,000 shortfall. The seller must pay the buyer $150,000. The effective purchase price is reduced by this amount.

 

 Structuring the Adjustment in the SPA

The Sale and Purchase Agreement (SPA) is the definitive legal document that governs the entire transaction. The clauses related to the working capital adjustment must be drafted carefully to minimize the potential for disputes.

 

The Working Capital True-Up SPA Clause

The “true-up” clause outlines the post-closing process. It typically specifies:

  • Timeline: A period, often 60 to 90 days post-closing, for the buyer to prepare and deliver a “Closing Statement” detailing their calculation of the actual closing NWC.
  • Review Period: A period, often 30 days, for the seller to review the Closing Statement and raise any objections.
  • Dispute Resolution: A mechanism for resolving disagreements. If the parties cannot agree, the matter is typically referred to an independent accounting firm, whose decision is binding. The costs of this expert are often split or paid by the losing party.
  • Accounting Principles Hierarchy: The clause must specify the accounting principles to be used for preparing the Closing Statement. Critically, this is often defined as being consistent with the target’s past practices, even if those practices deviate slightly from GAAP, to ensure an “apples-to-apples” comparison with the data used to set the peg.

Setting the Working Capital Peg Tolerance Band (Collar)

To avoid disputes over immaterial amounts, the SPA can include a “collar” or “tolerance band” around the peg. This creates a range within which no adjustment payment is made.

  • Structure: The collar can be structured in several ways. A common approach is a “tipping basket,” where if the deviation is within the band (e.g., +/- $50,000 of the peg), no payment is made. However, if the deviation exceeds the band, the full amount of the deviation (from the first dollar) is paid.
  • Example: Assume a $2M peg and a +/- $50k collar. If the actual NWC is $2,030,000, no adjustment occurs. If the actual NWC is $2,060,000, the buyer pays the seller the full $60,000.

 

Completion Accounts vs. Locked Box Mechanisms

 

The working capital true-up is the hallmark of the “Completion Accounts” mechanism, common in North America. However, an alternative, the “Locked Box” mechanism, is prevalent in Europe and gaining traction elsewhere.

Completion Accounts

  • Mechanism: The purchase price is adjusted post-closing based on a balance sheet prepared as of the closing date. This involves the true-up process described above.
  • Pros: Provides high accuracy, as the adjustment is based on the actual financial position at closing.
  • Cons: Can lead to lengthy and costly post-closing disputes. The final purchase price remains uncertain for months after the deal closes.

Locked Box

  • Mechanism: The purchase price is fixed based on a historical balance sheet date (the “locked box date”) well before signing. The seller guarantees that no value (“leakage”) has been extracted from the business between the locked box date and closing, other than permitted leakage (e.g., ordinary course salaries). The economic risk and reward of the business transfer to the buyer from the locked box date.
  • Pros: Provides certainty on the purchase price at signing. Avoids post-closing adjustment disputes.
  • Cons: The buyer bears the risk of poor performance between the locked box date and closing. Requires deep due diligence on the locked box balance sheet.

 

 Common Pitfalls and Disputes

Disputes over working capital adjustments are common and often stem from ambiguities in the SPA or differing interpretations of accounting principles.

Misclassifying Assets/Liabilities

A frequent point of contention is whether an item is operational (part of NWC) or financial (debt-like). For example, a seller might classify a large, overdue payable to a related party as a trade payable (part of NWC), while a buyer might argue it is a form of financing and should be treated as a debt-like item to be deducted from the price.

Inconsistent Accounting Policies

The buyer may want to apply their own, more conservative accounting policies to the closing statement (e.g., more aggressive reserves for bad debt or inventory obsolescence). The seller will insist on using the same policies and procedures that were used historically to calculate the peg. The SPA must be crystal clear that the closing statement should be prepared “in a manner consistent with past practice.”

The Challenge of Deferred Revenue in Working Capital

Deferred (or unearned) revenue is one of the most contentious items. It represents cash received by the company for services or products yet to be delivered. From an accounting perspective, it is a liability. Sellers generally treat it as part of normal NWC, arguing that the cash is already in the business and the liability will be worked off in the ordinary course, so no special adjustment is needed. Buyers, in contrast, often treat deferred revenue like debt, since they inherit the obligation to deliver the services without receiving new cash, and may push for a price reduction to reflect this liability. The SPA should clearly define how deferred revenue is handled.

 

Practitioner Notes: Advanced Considerations

 

Strategic Manipulation and Window Dressing

Be aware that sellers may be incentivized to artificially inflate NWC just before closing. This “window dressing” can include accelerating collections of receivables (pulling sales forward) or delaying payments to suppliers. Thorough due diligence, including a review of cash receipts and disbursements around the closing period, is essential to detect such behavior. A well-constructed QoE report will often identify these patterns by analyzing trends in key working capital metrics like Days Sales Outstanding (DSO) and Days Payable Outstanding (DPO).

 The Role of the Quality of Earnings (QoE) Report

A buyer-side QoE report is the primary analytical tool used to propose a working capital peg. The report provides a deep dive into the company’s historical earnings and balance sheets, identifying necessary normalization adjustments and recommending a normalized NWC target. As a buyer, the QoE report is your primary ammunition in the negotiation. As a seller, anticipating the buyer’s QoE analysis and preparing your own defensible calculation is critical.

 

 Glossary of Key Terms

 

  • Net Working Capital (NWC): The difference between current operating assets and current operating liabilities. It represents the short-term liquidity required to run the business.
  • Working Capital Peg: The pre-agreed, normalized target level of NWC that the seller must deliver to the buyer at closing.
  • Working Capital Adjustment: The post-closing mechanism to adjust the purchase price based on the difference between the actual closing NWC and the NWC peg.
  • True-Up: The post-closing process of calculating the final adjustment amount.
  • Sale and Purchase Agreement (SPA): The primary legal contract that governs the terms and conditions of the M&A transaction.
  • Completion Accounts: A mechanism where the final price is determined by a balance sheet prepared at the closing date, incorporating a working capital true-up.
  • Locked Box: A mechanism where the price is fixed based on a historical balance sheet, with the seller indemnifying the buyer for any value leakage until closing.
  • Deferred Revenue: Cash received for goods or services not yet delivered. It is a liability on the balance sheet and a frequent point of contention in NWC negotiations.

 

 Frequently Asked Questions (FAQs)

 

  1. What is the purpose of a working capital peg?
    The working capital peg is the target amount of cash needed to run the business post-sale, ensuring the buyer doesn’t have to inject extra funds immediately.
  2. What is a working capital peg tolerance band or collar?
    A tolerance band, or collar, is a negotiated range around the working capital peg (e.g., +/- $50,000). If the final deviation between the actual NWC and the peg falls within this range, no adjustment payment is made. It is used to avoid disputes over immaterial amounts.
  3. Why is deferred revenue a contentious item in working capital?
    Deferred revenue is contentious because buyers must fulfill service obligations for cash already paid to the seller. Consequently, buyers often treat it as a debt-like liability that should reduce the purchase price, while sellers consider it a normal part of working capital.
  4. What is the difference between completion accounts vs locked box working capital mechanisms?
    With completion accounts, the price is adjusted after the deal closes, so the final amount is uncertain. With a locked box, the price is fixed before the deal, giving certainty but shifting performance risk to the buyer.
  5. What is a “true-up” in the context of a working capital SPA clause?
    A “true-up” is the entire post-closing process defined in the SPA for finalizing the purchase price. It involves the buyer preparing a closing statement, the seller reviewing it, and both parties agreeing on the final working capital adjustment amount, leading to a potential payment from one party to the other.
  6. Who pays whom in a working capital adjustment?
    It depends on the outcome. If the actual net working capital at closing is higher than the agreed-upon peg, the buyer pays the seller for the excess. If the actual NWC is lower than the peg, the seller must reimburse the buyer for the shortfall.