Working Capital Adjustments Explained: The Hidden Cost of Buying a Business

What the working-capital peg is

Most M&A deals close on a "cash-free, debt-free" basis but assume the business comes with a normalized amount of working capital — enough to operate day-1. The "peg" is the dollar amount of working capital the buyer expects at close. Anything above is paid to the seller; anything below reduces the purchase price.

Why it matters

For a $2M business, working capital can swing $200K–$400K month to month based on seasonality, customer payment timing, and inventory cycles. Without a peg, the seller could drain receivables and stretch payables right before close — handing you a business that needs $200K of working capital injection on day 1.

How the peg is set

Standard methods (in order of frequency):

- **Trailing 12-month average** — sums monthly working capital balances over the last year and divides by 12. Smooths seasonality. Most common.

- **Trailing 6-month average** — more recent, but vulnerable to short-term swings.

- **Last 3-month average** — useful for businesses with structural changes; risky for seasonals.

- **Forward-looking budget** — only used when historical data is unreliable.

The components

Working capital = (current assets — cash) — (current liabilities — debt). Specifically: accounts receivable + inventory + prepaid expenses, MINUS accounts payable + accrued expenses + deferred revenue. Cash and debt are handled separately on the cash-free/debt-free principle.

Where the fights happen

- Is deferred revenue included? (Buyers want it counted as a liability; sellers want it excluded.)

- Is excess/obsolete inventory at full value or written down? (Buyer wants writedowns.)

- A/R older than 90 days — at face value, discounted, or excluded?

- Accrued bonuses, vacation, and other employee liabilities — current period or whole accrual?

How it settles at close

Estimated working capital is calculated 3–5 days before close. The purchase price is adjusted by (estimate — peg). Then 60–90 days post-close, a true-up: actual working capital at close vs the estimate, with cash flowing between parties. Escrow ($50–150K typical) is often held back for this.

Buyer tactics

Insist on a 12-month average methodology with explicit treatment of A/R aging and inventory writedowns. Get an example calculation in the LOI based on the most recent month. Require the seller to maintain "ordinary course" working capital during diligence (no draining A/R, no stretching A/P).

Seller tactics

Push for a recent (3- or 6-month) average if working capital has been declining. Define "ordinary course" precisely. Cap any post-close adjustment at a reasonable amount (e.g., $100K). Don't agree to a peg before seeing the methodology in writing.

What to remember

The peg is not academic. On a typical SMB deal, it's worth 3–8% of purchase price. Spend an extra hour on it in the LOI; you'll save days of fighting later.