The buyer's draft purchase agreement specifies a cash-free, debt-free deal with a normalized net working capital peg, but their proposed working capital calculation uses an arbitrary twelve-month average that starves our operating cash. How do we establish a fair working capital target?

Question

Tyler Smith · Accepted Answer

In a standard debt-free, cash-free transaction, the net working capital peg is one of the most frequently abused mechanisms used by buyers to claw back purchase price at the closing table. The peg represents the target dollar amount of working capital (current assets minus current liabilities) that you are required to leave behind in the company bank accounts and balance sheet on the day of closing to support normal operations.

If your actual working capital at close is one dollar below the agreed peg, the buyer docks your purchase wire dollar-for-dollar. If it is higher, they pay you the excess.

The conflict emerges when determining what constitutes normal working capital. Buyers often attempt to define the peg using an unadjusted trailing twelve-month average during a period of rapid business growth. If your company grew thirty percent over the last year, a twelve-month average artificially depresses the required working capital target, forcing you to fund their post-close growth out of your own cash reserves.

To negotiate a fair working capital target:
- Narrow the measurement window to a trailing three-month or six-month median if your business is expanding rapidly. This reflects your current operational realities rather than outdated historical cycles.
- Exclude non-operating current assets and liabilities. Cash must be excluded entirely in a cash-free deal, while all outstanding transaction bonuses, shareholder distributions, and aged uncollectible receivables must be eliminated from the peg formula.
- Establish a reasonable working capital collar or deadband. Agree that no adjustment to the purchase price will occur unless the closing working capital deviates from the target peg by more than two to three percent.

Lock down the definitive working capital methodology during LOI negotiations so you avoid a surprise shortfall on your closing wire.