Working Capital Peg Negotiations - Where Deal Value Shifts Between Buyers and Sellers

You spent eighteen months negotiating a $12 million purchase price. The letter of intent is signed. Due diligence proceeds smoothly. Then the buyer’s quality of earnings team delivers their working capital analysis, and you may face a significant reduction in what you’ll actually receive at closing—not because the price changed, but because of a number you barely discussed during headline negotiations.

Executive Summary

Working capital peg negotiations represent one of the most consequential financial discussions in lower middle market transactions, yet many sellers focus almost exclusively on headline purchase price while this parallel negotiation quietly determines their actual proceeds. The normalized working capital target—the “peg”—establishes a benchmark that your business must deliver at closing, with purchase price adjusting dollar-for-dollar based on delivered working capital compared against this agreed target.

In our firm’s experience advising sellers through lower middle market transactions, working capital methodology disputes commonly shift $50,000 to $300,000 in seller proceeds, with complex situations occasionally exceeding these ranges when parties use legitimately different methodologies to calculate what “normal” working capital should be. Industry data suggests that working capital requirements vary substantially by sector—typically 8-15% of revenue for service businesses, 15-25% for manufacturing, and 18-30% for distribution—making methodology selection particularly consequential.

The mechanics appear deceptively simple: if your agreed peg is $1.2 million and you deliver $1.0 million at closing, the purchase price reduces by $200,000. But determining that $1.2 million target involves complex decisions about historical averaging periods, normalization adjustments, seasonal variations, and line-item definitions that create substantial room for legitimate disagreement.

This article examines the working capital peg negotiation dynamics that sophisticated sellers must understand, identifies common methodology disputes where reasonable parties reach different conclusions, provides frameworks for protecting your interests through disciplined analysis and documentation, and acknowledges where negotiations can go wrong even with careful preparation.

Introduction

When business owners imagine their exit negotiations, they picture dramatic discussions about enterprise value, earnout structures, and strategic synergies. The reality is more prosaic but equally consequential: some of the most impactful negotiations happen in conference rooms filled with accountants arguing about receivables aging and inventory valuation methodologies.

Working capital adjustments exist for a legitimate purpose, particularly for businesses with traditional working capital needs such as manufacturing, distribution, and services with significant receivables and inventory. Buyers are purchasing a business that requires a certain level of operational capital to function—receivables that will convert to cash, inventory that will become sales, prepaid expenses that provide future value. They’re also assuming current liabilities that will require payment. The working capital peg ensures buyers receive a business with adequate operational capital while preventing sellers from stripping cash and stretching payables before closing.

The challenge is that “adequate operational capital” is not a precise number. It requires judgment calls about what historical period best represents normal operations, which items belong in working capital versus other categories, how to treat seasonal fluctuations, and what adjustments normalize for unusual items. Each of these decisions can shift the target by tens or hundreds of thousands of dollars.

For lower middle market transactions, working capital requirements vary significantly by industry. Service businesses typically maintain working capital of 8-15% of revenue, while manufacturing businesses often require 15-25%, and distribution companies may need 18-30% depending on inventory turns and payment terms. A $10 million revenue manufacturing business might have “normal” working capital of $2.0 million—but reasonable analyses might produce targets anywhere from $1.7 million to $2.3 million depending on methodology. That $600,000 range represents real money that either stays with you or goes to the buyer.

Understanding working capital peg negotiations is crucial for sellers who want to maximize their proceeds—though we should acknowledge upfront that even well-prepared sellers sometimes face unfavorable outcomes because of factors beyond their control, including market leverage, buyer sophistication, and timing constraints. This knowledge separates sophisticated sellers from those who discover too late that they negotiated the wrong number.

The Mechanics of Working Capital Adjustments

Working capital adjustments function as a true-up mechanism that ensures the business delivered at closing contains appropriate operational capital. The concept is straightforward, but the execution involves multiple moving parts that create negotiation opportunities—and risks.

How Purchase Price Adjustments Work

The purchase agreement establishes a target working capital amount—the peg—based on what the parties agree represents normal operational working capital needs. At closing, actual working capital is calculated using the agreed methodology. The difference between delivered working capital and the target adjusts the purchase price dollar-for-dollar.

If you deliver working capital above the target, you receive additional proceeds. If you deliver below the target, your proceeds decrease. This seems symmetrical, but the dynamics often favor buyers because they typically control the calculation timing and methodology interpretation after closing.

Most transactions use a “true-up” mechanism where an estimated working capital figure is used at closing, with a post-closing adjustment within 60 to 90 days when actual figures are finalized. This creates a second negotiation after closing when sellers generally have less leverage and the buyer controls the books.

Typical Working Capital Components

Working capital calculations typically include current assets minus current liabilities, but not all current items are treated equally. Common included items are:

Current Assets: Accounts receivable, inventory, prepaid expenses, and deposits. Cash is typically excluded because it’s addressed separately in the purchase price structure.

Current Liabilities: Accounts payable, accrued expenses, customer deposits, deferred revenue, and accrued payroll and benefits.

But specific items often get carved out based on how they’re addressed elsewhere in the transaction. Debt-like items might be excluded from working capital and treated as debt in the enterprise-to-equity bridge. Transaction bonuses or severance might be treated separately. The specific inclusions and exclusions significantly impact the target.

Why This Matters More Than Headline Price

Consider this scenario based on patterns we’ve observed across dozens of lower middle market transactions: You negotiate a $10 million purchase price for your manufacturing business and feel good about the outcome. The working capital peg is set at $1.8 million based on the buyer’s analysis—representing approximately 18% of your revenue. You don’t scrutinize it closely because you’re focused on the bigger number.

At closing, your actual working capital is $1.5 million—lower than normal because you accelerated some collections and your seasonal inventory was lower than the annual average. The purchase price reduces by $300,000 to $9.7 million.

If you had negotiated the peg at $1.55 million instead of $1.8 million—an entirely reasonable outcome with different averaging methodology—your adjustment would have been only $50,000 instead of $300,000. That $250,000 difference has exactly the same economic impact as negotiating a $250,000 higher purchase price, but it received a fraction of the attention.

Historical Analysis Methodologies and Their Impact

Determining the working capital peg requires analyzing historical data to establish what “normal” working capital looks like for your business. The methodology choices in this analysis create significant variability in the resulting target.

Averaging Period Selection

The most fundamental question is which historical period to analyze. Common approaches include:

Trailing Twelve Months: Uses the most recent twelve months of data. This approach captures current business dynamics but may be skewed by recent unusual events or seasonal timing.

Twenty-Four Month Average: Smooths out annual variations and provides more data points. But it may include periods that no longer represent how the business operates.

Monthly Average with Seasonal Adjustment: Calculates average working capital for each month across multiple years, then applies a methodology to address seasonal variations. This is more sophisticated but introduces additional judgment calls.

The averaging period selection can significantly impact results. In growing businesses, trailing twelve-month averages often exceed twenty-four-month averages because working capital needs increase with revenue. Conversely, in declining businesses, shorter periods may produce lower targets. Neither party’s preference is inherently wrong—they reflect different but legitimate views of “normal.”

Point-in-Time Versus Average Approaches

Some buyers propose using a single point-in-time measure—often the most recent month-end or year-end—rather than an average. This approach is generally less favorable for sellers of stable or growing businesses because it doesn’t smooth out normal fluctuations and can be influenced by timing. But declining businesses or those with recent working capital improvements may benefit from more recent point-in-time measures that capture current operational reality.

If your business has seasonal patterns, a point-in-time measure might capture a peak working capital period that significantly exceeds what the business typically maintains. Transaction professionals commonly observe that seasonal businesses may experience working capital fluctuations of 25-50% between peak and trough periods. We generally recommend sellers of stable or growing businesses push for averaging approaches that reflect normal operating patterns rather than snapshots—though this preference should be weighed against specific circumstances.

Treatment of Outliers

Historical data often includes unusual months—perhaps you had a large customer pay slowly one quarter, or you built inventory ahead of a product launch. How these outliers are treated affects the average.

Buyers may argue that outliers should be removed only when they reduce working capital, leaving high-working-capital periods in the calculation. Sellers should insist on symmetrical treatment: if unusually low periods are normalized, unusually high periods should be as well.

Industry-Specific Working Capital Dynamics

Working capital negotiations play out differently across industries, and understanding your sector’s norms strengthens your negotiating position.

Manufacturing Businesses

Manufacturing companies typically maintain the highest working capital levels relative to revenue, often 15-25% based on industry benchmarks and transaction experience. Key negotiation points include:

• Raw materials and work-in-process inventory: Valuation methodology (FIFO versus LIFO, standard cost variances) significantly impacts totals
• Finished goods seasonality: Build-ahead for busy seasons creates timing challenges
• Supplier payment terms: Changes in vendor relationships during the transaction period can distort historical averages

Service Businesses

Service companies generally maintain lower working capital, typically 8-15% of revenue, but face distinct challenges:

• Unbilled receivables: Treatment of work-in-progress on long-term projects creates definitional disputes
• Deferred revenue: Customer prepayments can substantially impact liability calculations
• Minimal inventory: Working capital composition differs fundamentally from product businesses

Note that some service models—particularly SaaS businesses with annual prepayments—may operate with negative working capital, making standard working capital analysis less applicable.

Distribution and Retail

Distribution businesses often fall between manufacturing and service, typically 18-30% of revenue, with key issues including:

• Inventory turns: Slow-moving inventory reserves become significant negotiation points
• Seasonal inventory builds: Retail businesses may double or triple inventory for peak seasons
• Vendor rebates and allowances: Treatment of earned-but-not-received amounts affects both assets and liabilities

Understanding these industry patterns helps you identify when a buyer’s proposed target falls outside reasonable ranges for your sector.

Normalization Adjustments and Common Disputes

Beyond selecting the historical period, both parties typically propose normalization adjustments that modify raw historical figures to better reflect ongoing operations. These adjustments are where sophisticated negotiation creates or destroys value.

Accounts Receivable Normalization

Receivables adjustments commonly address:

Aging and Collectibility: Buyers may propose reserves against older receivables, arguing they represent collection risk. The reserve methodology—whether based on your historical write-off experience or industry benchmarks—significantly impacts the calculation. If your historical bad debt rate is 0.5% but the buyer proposes using a 3% industry benchmark, that difference directly affects your peg.

Customer Concentration Effects: Large receivable balances from key customers may be scrutinized for collection risk or normalized based on payment timing patterns.

Related-Party Receivables: Amounts owed by related parties often get excluded or reserved entirely, regardless of collectibility history.

We’ve observed receivables normalization adjustments shift working capital targets by 5-15% of total receivables in typical lower middle market transactions. Sellers should ensure adjustments reflect actual historical experience rather than theoretical risks.

Inventory Valuation Disputes

Inventory creates particularly complex normalization discussions:

Slow-Moving and Obsolete Inventory: Buyers frequently propose reserves against inventory that hasn’t sold recently. The methodology for determining “slow-moving” thresholds and reserve percentages significantly impacts results. A common dispute: buyers propose reserving 100% of inventory over 12 months old, while sellers argue their historical experience shows 80% of such inventory eventually sells at full margin.

Valuation Methodology: LIFO versus FIFO differences, standard cost variances, and capitalized overhead allocation all affect inventory values.

Seasonal Inventory Levels: If your analysis period captures peak inventory seasons, the average will exceed what the business typically needs.

Inventory disputes are especially contentious in manufacturing and distribution businesses where inventory represents 40-60% of total working capital.

Prepaid Expenses and Accruals

Prepaid expenses seem straightforward but create disputes around:

Prepaid Insurance and Deposits: Large annual prepayments can skew monthly averages depending on timing.

Capitalization Policies: Different interpretations of what should be expensed versus capitalized as prepaid affects working capital.

On the liability side, accrual completeness becomes a battleground. Buyers may argue that historical accruals were understated, requiring normalization that increases the target. Sellers should ensure any accrual adjustments reflect actual historical patterns rather than theoretical “should-be” amounts.

Seasonal Variation Treatment

Businesses with seasonal patterns face additional complexity because working capital naturally fluctuates throughout the year. How seasonal variation is addressed significantly impacts both the target and the closing adjustment calculation.

Quantifying Seasonal Impact

Seasonal businesses commonly experience working capital fluctuations of 25-50% between high and low periods based on transaction experience and industry observations. For a business with $1.5 million average working capital, this could mean swings from $1.1 million to $1.9 million throughout the year.

If your closing occurs at a seasonal low point but your peg was set using an annual average, you face an immediate negative adjustment even though your business is operating normally. Understanding your seasonal patterns—and quantifying them precisely—is needed.

Seasonal Target Approaches

Three common approaches address seasonality:

Annual Average Target: Uses a single annual average figure regardless of closing timing. This is simple but creates timing incentives—sellers prefer closing at low working capital periods, buyers prefer closing at high periods.

Monthly Seasonal Targets: Establishes different targets for different months based on historical seasonal patterns. More complex but fairer for seasonal businesses.

Collar or Band Approach: Sets a range around the target where no adjustment occurs, with adjustments only for deviations outside the band. This reduces adjustment magnitude but can still favor one party depending on band construction.

Closing Date Selection

For seasonal businesses, closing date selection interacts with working capital treatment. If you’re using an annual average target, closing in a low working capital month means you’ll likely face a negative adjustment even if your business is operating normally.

Sophisticated sellers consider working capital implications when negotiating closing timelines. Closing in a month when working capital naturally approximates the annual average minimizes adjustment risk and simplifies post-closing true-up negotiations.

When Working Capital Negotiations Go Wrong

Understanding what can go wrong—even with preparation—helps set realistic expectations and identifies warning signs early.

Case Study: The Seasonal Mismatch

A seasonal consumer products business agreed to a working capital peg based on trailing twelve-month average data. The seller didn’t fully appreciate that the twelve-month period captured an unusual inventory build for a new product launch. The peg was set approximately $280,000 higher than typical operating levels.

When closing occurred during a normal operating month, the seller faced an unexpected $280,000 reduction. Despite protests, the calculation followed the agreed methodology precisely. The lesson: understand not just the methodology but also what specific data points drive the result.

Case Study: The Post-Closing Dispute

A manufacturing business closed with estimated working capital near the target. During the 90-day true-up period, the buyer’s accountants reclassified $150,000 of receivables as “doubtful” based on aging criteria not explicitly defined in the purchase agreement. The seller disputed this reclassification but faced a choice: accept the adjustment or spend $50,000+ on arbitration with uncertain outcome.

The seller ultimately accepted a negotiated $100,000 adjustment—still a significant unexpected reduction. The lesson: vague definitions create post-closing vulnerability.

Case Study: The Leverage Shift

A seller conducted thorough pre-sale analysis and identified that the buyer’s proposed methodology produced a target $200,000 higher than the seller’s preferred approach. But the transaction occurred in a buyer’s market with limited competition. Despite compelling analysis, the seller lacked leverage to negotiate favorable methodology and accepted the buyer’s approach.

The lesson: preparation improves outcomes but doesn’t guarantee them. Market conditions and competitive dynamics ultimately influence negotiating leverage.

Case Study: The Favorable Surprise

Not all working capital adjustments disadvantage sellers. A distribution business closed during a month when inventory had been drawn down for a large customer order, but the peg was set using annual averages. The seller delivered working capital $180,000 below target—but the business quickly rebuilt inventory post-closing, and the buyer effectively paid fair value for a temporarily low position. While approximately 30-40% of working capital true-ups favor sellers when delivered working capital exceeds the target, this case shows that timing can work in either direction.

Protecting Seller Interests Through Disciplined Negotiation

Understanding working capital mechanics is needed, but translating that understanding into protected proceeds requires deliberate negotiation strategies—and realistic expectations about what’s achievable given market conditions.

Conduct Your Own Analysis First

Before receiving the buyer’s working capital analysis, conduct your own detailed review. Calculate working capital using multiple methodologies and understand the range of reasonable outcomes. This preparation prevents you from anchoring to the buyer’s number and identifies where your legitimate interests diverge.

Important caveat: Sellers should conduct analysis to understand the range of reasonable outcomes, but avoid proposing higher targets than buyers suggest. Use analysis defensively to evaluate buyer proposals rather than proactively to suggest alternatives that could work against your interests.

Your analysis should document:

• Monthly working capital for at least 24 months
• Multiple averaging approaches and their results
• Unusual items requiring normalization
• Seasonal patterns and their magnitude
• The range of reasonable target outcomes

Negotiate Definitions Early—When Possible

Ideally, working capital definitions should be negotiated at the letter of intent stage, not left for purchase agreement drafting. But we should acknowledge that most LOIs contain only basic working capital language, and buyers often resist detailed working capital negotiations until due diligence. At minimum, sellers should ensure LOI language doesn’t preclude favorable methodology arguments during purchase agreement negotiation.

When you can negotiate definitions, key elements include:

Included and Excluded Items: Specify exactly which balance sheet lines are included. Don’t accept vague “consistent with GAAP” language without specificity.

Calculation Methodology: Define whether you’re using book values, adjusted values, or specific valuation methodologies for inventory and receivables.

Dispute Resolution: Establish clear procedures for resolving disagreements in post-closing true-up calculations, including escalation to independent accountants and how their fees are allocated.

Document Everything

Working capital negotiations should produce detailed documentation of agreed methodologies, normalization approaches, and calculation examples. This documentation becomes critical during post-closing true-up when memories differ and leverage has shifted.

We recommend sellers insist on calculation examples attached to the purchase agreement showing exactly how working capital will be calculated for different scenarios. These examples reduce post-closing disputes by clarifying ambiguities before closing.

Understand the True-Up Process

Post-closing true-up creates significant risk for sellers. The buyer controls the books after closing and prepares the initial working capital calculation. You have limited time to review and object, and disputes may require expensive third-party resolution.

Negotiate favorable true-up terms including:

• Adequate review period (at least 45 days) for your accountants to analyze the buyer’s calculation
• Access to books and records during review
• Clear dispute resolution procedures with reasonable cost allocation
• Caps on adjustment magnitude where appropriate

When to Invest in Professional Support

Engaging M&A counsel and accounting advisors with specific transaction experience provides significant value—but this investment should be proportionate to the potential impact. Expect to invest $50,000-$100,000 in professional working capital analysis and negotiation support for complex transactions.

This level of investment is typically justified when:

• Potential working capital impact exceeds $150,000-$200,000
• Business complexity creates significant methodology risks
• Competitive process provides leverage to negotiate favorable terms
• Seasonal or industry-specific factors require specialized analysis

For simpler businesses with minimal working capital impact—particularly those where potential adjustment is sub-$50,000—sellers may reasonably rely on less extensive analysis, especially in competitive processes where relationship preservation matters more than methodology optimization.

Market Conditions and Leverage Reality

The negotiation strategies outlined above work best in competitive processes with multiple interested buyers. In single-buyer situations or buyer’s markets, even well-prepared sellers may face limited ability to negotiate favorable working capital terms.

Factors that strengthen seller leverage:

• Multiple competing buyers
• Strong business performance and clean financials
• Experienced transaction advisors
• Seller willing to walk away from unfavorable terms

Factors that weaken seller leverage:

• Single buyer or limited competition
• Time pressure to close
• Business challenges that reduce buyer interest
• Seller financially dependent on transaction closing

When leverage is limited, sellers should consider focusing negotiation energy on other deal terms—earnout structures, representations and warranties, indemnification caps—where they may have more success. Accepting market working capital treatment while winning concessions elsewhere may produce better overall outcomes than fighting unwinnable working capital battles.

Working Capital Methodology Comparison

The following table summarizes key methodology choices, their typical impact, and when each approach may be most appropriate:

Actionable Takeaways

Working capital peg negotiations deserve attention proportional to their financial impact. Here’s a practical implementation timeline:

12+ Months Before Exit:

• Begin tracking monthly working capital with consistent methodology
• Identify seasonal patterns and quantify fluctuation ranges
• Document unusual items that may require normalization
• Research industry benchmarks for working capital ratios in your sector

6-12 Months Before Exit:

• Conduct detailed working capital analysis using multiple methodologies
• Calculate the range of reasonable target outcomes for your business
• Identify potential normalization disputes and prepare supporting documentation
• Assess whether professional support is cost-justified based on potential impact

During Letter of Intent Negotiation:

• Attempt to negotiate specific working capital definitions alongside purchase price, acknowledging that buyers may resist detailed discussion until due diligence
• Address seasonal variation treatment explicitly when possible
• Establish favorable true-up procedures and timelines
• Document methodology with attached calculation examples where feasible

During Due Diligence:

• Scrutinize buyer’s working capital analysis for methodology consistency
• Challenge normalization adjustments that lack symmetrical treatment
• Monitor working capital levels to anticipate closing adjustments
• Prepare for post-closing true-up by maintaining detailed records
• Use analysis defensively to evaluate buyer proposals

Post-Closing:

• Review buyer’s working capital calculation promptly and thoroughly
• Engage accounting support during the review period
• Document any disputes with specific reference to agreed methodology
• Understand when accepting a negotiated settlement makes economic sense versus pursuing formal dispute resolution

Conclusion

Working capital peg negotiations represent a consequential battlefield in M&A transactions where tens to hundreds of thousands of dollars can shift between buyers and sellers based on methodology decisions that receive far less attention than headline purchase price. For lower middle market business owners, understanding these mechanics is vital to ensuring that your carefully negotiated enterprise value actually translates into expected proceeds.

The complexity of working capital negotiations argues for experienced advisors who understand both the technical accounting issues and the negotiation dynamics—when the potential impact justifies the investment. Quality of earnings analyses, detailed historical reviews, and sophisticated documentation require expertise that most business owners encounter only once in their careers. For transactions where working capital impact exceeds $150,000-$200,000, we recommend engaging M&A counsel and accounting advisors with specific transaction experience.

That said, even well-prepared sellers sometimes face unfavorable outcomes. Market conditions, buyer leverage, and transaction timing all influence results beyond methodology alone. The goal is not guaranteed success but rather informed negotiation that maximizes your probability of favorable outcomes while setting realistic expectations about what’s achievable given competitive dynamics.

We encourage business owners considering exits within the next two to seven years to begin understanding their working capital dynamics now. Analyzing your historical patterns, identifying potential normalization issues, and understanding seasonal variations prepares you for negotiations before they begin. The working capital discussion shouldn’t be where your proceeds quietly disappear—it should be another opportunity to demonstrate the quality of your business and protect the value you’ve built.