How is a working capital peg set in a business sale?

Start with the operating working-capital concept

In ordinary accounting language, working capital, also called net working capital, is the excess of current assets over current liabilities. FASB describes it as a relatively liquid portion of enterprise capital that provides a buffer for obligations in the ordinary operating cycle. Its examples include inventory and trade receivables on the asset side, and trade payables and operating accruals on the liability side. [1]

A sale-process peg uses that concept as a starting point, not as an automatic answer. The parties are deciding what operating resources and obligations the buyer should receive at closing so the business can continue in its normal pattern. The peg therefore normally focuses on accounts connected to revenue generation and day-to-day delivery. The agreement may exclude balances handled elsewhere in the purchase-price bridge, such as cash, funded debt, seller transaction expenses, or selected tax balances. The correct perimeter depends on the transaction and its documents.

Define the account perimeter before calculating a target

The most important early work is an account schedule. List each proposed account, its ordinary balance direction, the ledger or financial-statement source, and the proposed treatment. Typical candidates can include trade accounts receivable, inventory, prepaid operating costs, accounts payable, accrued payroll, customer deposits, and other operating accruals. Do not assume that the word “current” resolves the question. A current balance may be cash-like, debt-like, nonoperating, transaction-related, or already addressed by another adjustment.

For every account, ask what economic service it represents at closing. Does it fund inventory or receivables needed to fulfill orders? Does it arise from ordinary purchases or payroll? Is it a financing balance, an owner-related balance, or a one-time item? In one SEC-filed agreement, net working capital used specified receivables, inventory, trade payables, and selected accrued expenses, while prepaid insurance, prepaid taxes, and other prepaid expenses were excluded. [2] Read the operative definition rather than importing a generic formula.

Use historical balances, but do not let one month set the peg

A defensible target usually begins with monthly or quarterly historical balances over a period that captures the business’s normal cycle. Reconcile the working-capital schedule to the general ledger and financial statements, then investigate changes in the account mix. The objective is not to choose the highest or lowest historical balance. It is to identify the level that ordinarily supports the revenue and operating cadence the buyer is acquiring.

Review receivable days, inventory turns, payable timing, accrued payroll, customer deposits, and unusual movements together. A balance can rise because sales grew, collection slowed, a purchase was brought forward, or a classification changed. Those causes have different implications. Preserve the monthly detail so the other side can reproduce the analysis. The benchmark should be explainable by operating facts, not an unexplained average or selected closing date.

Adjust the analysis for seasonality and known changes

Seasonality is central for distributors, manufacturers, wholesalers, and other businesses whose inventory, receivables, or payables expand at predictable times. Compare the proposed peg with the same seasonal periods in prior years where those records are reliable. A simple annual average can understate the working capital needed before a peak selling period and overstate it after the cycle turns. The right method depends on the business’s pattern, growth, mix, and record quality.

Separate recurring seasonality from a temporary distortion. Examples include a one-time bulk purchase, customer dispute, stockout, delayed supplier payment, acquisition, or unusual collection push. Also identify changes expected to continue after closing, such as a new customer contract, plant expansion, changed payment term, or discontinued product line. Document whether the target reflects the historical business, the agreed post-closing perimeter, or a specific normalized operating case. Material change may require a tailored method rather than a mechanical average.

Make receivables and inventory policies explicit

Receivables and inventory often carry the most judgment. For receivables, define whether the schedule uses gross invoices or recorded receivables net of an allowance, and explain credits, returns, disputed invoices, customer deposits, and aged balances. Tie the method to an agreed reference period and identify who supplies the aging and reserve support. Do not present an estimate as a fact simply because it appears in the ledger.

For inventory, document the population, locations, ownership, consignment items, costing basis, obsolescence or excess-stock reserve, and cut-off procedures. The SEC-filed agreement specified valuation work for raw materials, work in progress, and finished goods, required a roll-forward, and contemplated a physical count observed by the parties’ representatives. [2] Those details illustrate the operational evidence that can matter when inventory is a large part of the peg.

Grant Thornton identifies allowance for doubtful accounts and inventory valuation as areas where estimates commonly create disagreement. It recommends addressing judgment-heavy items with specific accounting policies rather than relying only on broad “GAAP and consistent application” language. [3] Write down the decision rule while the parties can still compare records and assumptions.

Set a hierarchy for accounting judgments

A working-capital schedule needs a rule for matters that are not obvious from the ledger. A useful drafting sequence is: first, apply transaction-specific accounting policies; second, follow consistency with a clearly identified set of historical financial statements; third, apply the agreed accounting framework for matters not covered by the first two. Grant Thornton describes this hierarchy as a way to reduce ambiguity in closing-balance-sheet preparation. [3] Confirm the framework and effective date with advisers because standards and transaction terms vary.

Specify the reference statements by date and version. “Consistent with past practice” can be too broad if practices changed between monthly closes, year-end reporting, and management accounts. For each material estimate, state the supporting schedule, approval owner, and treatment of a new fact that did not exist in the reference period. If a negotiated commercial treatment differs from the historical books, say so directly instead of implying that it is an accounting requirement.

Test the proposed peg with a transparent bridge

Before signing, prepare an illustrative bridge from enterprise value to equity value using the proposed working-capital benchmark and the other agreed purchase-price adjustments. This is not a prediction of the final settlement. It exposes how the definition works with real balances. Change one account at a time and ask whether the result matches commercial intent. If a balance could be treated as working capital, debt-like, cash-like, or excluded, show the alternative and resolve the treatment in writing.

The bridge should identify the statement date, account source, currency, unit, accounting basis, and normalization adjustment. Keep the historical schedule, proposed target, and closing calculation conceptually separate. The target is a benchmark agreed before closing. The closing statement applies the agreed definitions to closing records. Mixing those stages can create arguments about a target that was never clearly defined.

Build a closing-ready process without deciding the settlement here

A practical implementation owner can create a workpaper with account mapping, monthly historical balances, seasonality support, policy decisions, and open questions. The finance owner should reconcile totals to the ledger. The deal lead should maintain the definition schedule and decision log. Counsel should review purchase-agreement wording and the dispute procedure. An accounting adviser, if engaged, should review judgment-heavy estimates under the agreed scope. Each reviewer should have a named source record and a stopping condition, such as no unresolved material classification or no unexplained difference between the schedule and financial statements.

Use a short pilot on two or three historical month-ends before finalizing the schedule. Stop and escalate if an account cannot be traced, a proposed policy changes the historical result materially, or the business perimeter differs between the reference period and the sale. Keep confidential records in the approved deal workspace, limit access to people who need them, and do not put customer-level information in a public article or unsecured working file. Human review remains responsible for the final definition, approvals, and disclosures.

What the owner should have before signing

The owner should aim to have an account-by-account definition, a historical schedule that shows seasonality, written treatments for receivable and inventory estimates, a defined accounting hierarchy, and an illustrative bridge. The package should identify excluded accounts and explain any balance handled elsewhere in purchase-price mechanics. These materials make the benchmark reviewable and help distinguish an operating change from a classification disagreement.

Acquivo gives business owners the entire sell-side process an investment bank would run, as software, with no success fee. The software is user-operated, so the owner and selected advisers remain responsible for source checks, permissions, review, and transaction decisions. Acquivo is a software platform that delivers the entire sell-side M&A process, valuation, marketing materials, buyer matching, and deal management, on one platform for business owners, M&A attorneys, and boutique investment banks.