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Hi, it's CJ Gustafson and welcome to Looking for Leverage.
Today's term: the net working capital peg, and more specifically the lookback period you use to set it.
When you sell your company, the buyer expects the business to come with a normal level of working capital already in it, like handing over a car with a full tank of gas. The peg is how much gas counts as full. And the number you land on depends almost entirely on which months you average to get there. That's a choice, it's negotiable, and it's worth real money to get right.
Setting the scene
My business was growing fast, call it 70% a year, and we were deep in the purchase agreement negotiation. Every economic term was settled except one that I'd been treating as an afterthought: the working capital target.
The buyer's draft set the peg as the average of our last three months of net working capital. It sounded reasonable enough… recent and current and a fair read on the business as it stood. So I almost initialed it.
Our advisor stopped me (which is what you pay advisors for!) He pointed out that because we were growing, our working capital was climbing every month, so the last three months were the highest three months in the trailing year. Pegging to them set the "full" mark as high as it had ever been. Remember, the buyer expects a full tank at close, and the peg defines what full means. Every dollar of working capital I delivered above that full mark would come back to me as proceeds. Every dollar below gets subtracted from our check.
Net net, the gap between those two windows was about $1.5M of purchase price. Let’s go deeper.
The dumb version
Net working capital is current assets minus current liabilities, with cash and debt stripped out. Another way to put it is Receivables plus Inventory plus Prepaids, minus Payables and Accruals. Functionally, it’s the money tied up in running the business day to day.
The peg, sometimes called the target, is the amount of that working capital the buyer expects to be delivered with the company at close. If you deliver more than the peg, the buyer pays you the difference; if you deliver less, they subtract it from your check, dollar for dollar. Doesn’t matter what your revenue or ebitda multiple is.
Working capital is cash you've tied up in the business. Your receivables are money customers owe you that you haven't collected, and your inventory is cash you spent on goods you haven't sold, so leaving more of it in the company means you've funded operations the buyer would otherwise have to bankroll the week after close (which would not only cost them money, but be a real logistical headache).
If there were no true-up, nothing would stop you from stripping the balance sheet before signing, collecting every receivable and paying no vendors, and handing over an empty tank. The adjustment exists to prevent exactly that, which is why it has to cut both ways (I.e., allow the seller to benefit too, when it goes over).
Everyone treats the peg like it falls out of a formula, but it really falls out of a lookback window that somebody in the deal chose, and that becomes more art than science.
Making it real
The peg is almost always built as an average of your net working capital over some number of trailing months. The fight is over how many months, and which ones (every company has “good” and “bad” months).
A lower peg is better for you as the seller, because your adjustment at close is your actual working capital minus the peg, so the lower the peg sits, the bigger that positive adjustment gets and the more money ends up with you.
The buyer wants the peg high enough that the business is fully funded on day one and they don't have to inject cash the week after close.
So you're pulling the peg down and they're pulling it up, and the lookback window is kinda like the rope.
As the seller, two things about your business decide which window helps you.
Growth:
If you're growing, you need more working capital every month to fund the larger book of receivables and inventory.
Your recent months are your highest months.
A short lookback window, like the last three months, captures those highs and sets a high peg.
A twelve-month average reaches back to smaller, older months and sets a lower peg.
Growing businesses generally want the longer window.
The buyer, knowing they'll need to fund the bigger business going forward, wants the shorter one.
Sometimes they'll skip averaging entirely and argue for a forward-looking peg built off projected revenue, which for a fast grower is not what you want.
Seasonality.
If your working capital swings with the calendar, the window interacts with your closing date in ways that can hand you money or take it away.
Say you build inventory every summer for a fall selling season. If you close in August at your seasonal peak, your actual working capital is high.
Peg that against a twelve-month average and you're way above the bar, which is a big positive adjustment to you.
Peg it against the last three months, which are also peak months, and the bar rises to meet your actual, and the adjustment shrinks.
Close in the winter trough instead and the whole thing inverts.
The point is that a seasonal business cannot pick a window without also thinking about when the deal closes, because the two together determine whether you're above or below your own peg.
The more sophisticated move on either side is to stop arguing about dollars and argue about days.
Instead of a fixed dollar peg, you set targets for days sales outstanding, days inventory, and days payable, and apply them to the actual revenue at close. For a growing business this is often the fairest frame, because the peg scales with the business instead of freezing a stale dollar figure. Whether that helps or hurts you depends on whether your recent efficiency is better or worse than your historical efficiency, so you run it both ways before you propose it.
None of this is about cheating the buyer (or at least shouldn’t be). The business does need a real level of working capital to run. It's about making sure the level you get held to reflects how your business actually breathes, instead of whichever three months happen to make the buyer's number look best.
The math (with numbers)
Say you're growing 70% a year and your monthly net working capital over the trailing twelve months climbed steadily from about $5.3M to about $9.0M. At close, your actual working capital is at the current level, roughly $9.0M.
Now look at what the window does to the peg:
Trailing twelve-month average: roughly $7.1M
Trailing three-month average: roughly $8.6M
It's the same balance sheet and the same business, and the only thing that changed is how far back you reached to build the average.
Run each through the close-date adjustment against your $9.0M actual:
Peg at $7.1M: adjustment is $9.0M − $7.1M = +$1.9M to you
Peg at $8.6M: adjustment is $9.0M − $8.6M = +$0.4M to you
So a $1.5M swing in your proceeds, and nobody touched the multiple the business is being valued on (whether that’s revenue or EBITDA).
Btw - If you'd let the buyer default to a forward-looking peg off next year's revenue, the number could have gone higher still and flipped your adjustment negative.
When it clicked
What I took from almost signing that three-month peg: the working capital target is one of the last economic terms to get settled and one of the least scrutinized, which is exactly why money leaks out of it. It’s almost never in the sellers favor, as the deal is “on the tracks” at that point. It left the station.
By the time you reach it, everyone's tired, the multiple's been fought over for weeks, and the peg feels like minor plumbing you can initial without wasting more time. That instinct is where the last few points of purchase price leak out.
What to do Monday
Three things, none of which require you to be in a process yet.
Build your net working capital as a trailing-twelve-month monthly schedule. Plot it. If the line is sloping up because you're growing, or sawtoothing because you're seasonal, you already know the peg is going to be a fight, and you want to see the shape long before a buyer does. It’s very helpful to see these things visually.
Model the peg under multiple windows: last three months, last six, last twelve, and a days-based version tied to revenue. Note which one gives you the lowest peg and keep that number in your back pocket. That's your opening position when the term comes up.
If your business is seasonal, map your working capital cycle against your likely closing window. If you can influence when the deal closes, closing when your actual working capital sits above a trailing-average peg is worth legit money, and it's the kind of thing nobody tells you until you've left it on the table once (almost guilty as charged).
Wishing you a lookback window that reaches back exactly as far as you need it to,
CJ
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