The net working capital (NWC) peg is the target amount of capital required to operate the business at time of acquisition. Sellers want to negotiate a lower peg and deliver higher actual NWC at close, and vice versa for buyers. Say the NWC peg is set at $10. If at close, the sellers deliver $12 of NWC, they would obtain a $2 increase to the final purchase price — they funded the business with an additional $2 of NWC and receive a dollar-for-dollar reimbursement. Alternatively, if the sellers deliver $8 of NWC, their proceeds would be reduced by $2. For business owners, this adjustment can meaningfully move your final proceeds — sometimes by hundreds of thousands of dollars — so it’s worth understanding before you get to the negotiating table. To be clear, I’m not taking a buyer or seller side in this article, simply trying to remain objective.
In a cash-free, debt-free transaction (see prior post), the buyer will want to take control of the business with the highest NWC peg. Put differently, without a working capital adjustment, they would want to take control when the working capital is at its highest — more working capital means more runway and less need to inject cash immediately after close. That said, what both parties should actually work towards is a normalized or steady-state level of NWC — one where neither side has an incentive to time the transaction. That principle of indifference is what makes a well-set peg fair to both sides, and it’s the framework for everything that follows.
How the peg gets set depends on whether there’s a credible reason for NWC to have recently shifted. “We’ve been optimizing our working capital” is not a credible reason. Neither is “our inventory increases this year are purely temporary; if you look at the prior few years, they’re not as high.” A credible reason looks like this: “we extended terms for our key customer over the last three months — here are the details of that communication and why those temporary terms are coming to an end next month.” Without that kind of specificity, here are the guidelines for how the peg should be set:
- The typical approach is a 12-month average — appropriate for businesses with relatively steady NWC month-to-month and, from a negotiation standpoint, represents a neutral middle ground that neither side can reasonably argue is tilted in their favor.
- If NWC has been steadily rising or falling in recent months without a credible explanation, the peg should reflect a shorter window — typically the most recent 3 or 6 months.
- If NWC is highly seasonal, the average should typically reflect your most active months. Isn’t that bad for the seller? Yes — and the sell-side will argue against it. But return to the core premise: indifference to the timing of the transaction. A peg based on active months, with a transaction closing during inactive months, simply requires the buyer to fund that NWC shortly after close to operate the business.
A common misunderstanding among deal professionals: there’s a push to get the peg set early in the process — this is misplaced effort. The right goal is to define NWC early, not set the peg early. No buyer will commit to a peg before diligence is complete and they’re confident the operations of the business aren’t changing. Pushing to set the peg prematurely doesn’t accelerate the deal — it creates confusion about the priority of workstreams across all teams involved. There’s other wood to chop.
If the peg is set correctly — at the normalized, steady-state level where neither side has an incentive to time the transaction — there should be little to dispute after the fact. A few examples of how this plays out:
- If accounts receivable goes up — great, the seller gets a dollar-for-dollar increase for winning that business; the buyer pays for it and collects the cash when customers pay their invoices.
- If inventory goes up — great, the seller paid for the inventory and reduced cash. That reduction is reimbursed dollar-for-dollar by the buyer, who gets the benefit of the inventory.
- If accounts payable goes up — the seller obtained additional inventory and has yet to pay for it. The two cancel each other out and NWC stays the same. The buyer takes over, pays off the invoices, and gets the inventory to sell.
When the peg is set right, NWC movements ahead of the close become a non-issue. That’s the whole point.