Every purchase agreement has a working capital section, and almost every first-time seller and more than a few first-time buyers treat it as boilerplate: a formula, an estimate, a true-up mechanism, initialed and moved past on the way to the exhibits everyone actually reads. That treatment is backwards. The working capital peg is one of the few deal terms that gets renegotiated after signing whether anyone planned to or not, and the true-up process is where a meaningful share of lower middle-market disputes actually happen, not because the arithmetic is hard, but because almost nobody agrees on the inputs until the number is already unwelcome.
This isn't a mechanical walkthrough of the formula, which is genuinely simple: current assets minus current liabilities, excluding debt and debt-like items, compared against a pre-agreed target. It's a walkthrough of the five places that simple formula quietly becomes a negotiation, usually discovered by whichever side didn't think to negotiate it up front.
What the peg is actually protecting against
The peg exists because a business needs a certain amount of working capital to keep operating normally, and that amount doesn't show up on a balance sheet as its own line item. If a buyer pays a fixed enterprise value assuming the business comes with enough receivables, inventory, and cash-on-hand to run itself, and the seller quietly lets receivables run down or stretches payables for sixty days before close, the buyer has effectively paid for something they didn't get: a business that can fund its own operations from day one. The peg is the mechanism that keeps a seller from harvesting working capital in the run-up to close, and, less discussed but just as real, keeps a buyer from claiming a shortfall where none exists.
That's the theory. In practice, the fight is never about the theory. It's about the five inputs below, each of which has a defensible-sounding argument on both sides, which is exactly why they get contested.
1. What actually counts as “working capital”
The purchase agreement will define net working capital with a list of included and excluded accounts, and that list is where the negotiation actually lives. A few line items that look like standard current assets or liabilities but frequently get reclassified, in one direction or the other, depending on who drafted the first version of the definition:
- Cash and cash equivalents: almost always excluded entirely, since cash is typically swept to the seller at close and handled separately in the purchase price mechanics. A buyer who lets cash slip into the NWC definition is effectively double-counting it.
- Current portion of deferred revenue: a real liability under GAAP, but arguably not a cash obligation in the way accounts payable is. Sellers push to exclude it; buyers, especially in software deals, push hard to include it, since it represents cash already collected for services not yet delivered.
- Accrued bonuses and accrued PTO: easy to underfund in the months before a sale process starts, which quietly inflates the seller's apparent working capital position if the accrual isn't caught and normalized.
- Intercompany and related-party balances: common in founder-owned businesses, and almost always need to be excluded or specifically addressed, since they don't reflect the target's real operating liquidity.
- Prepaid expenses tied to owner perks: a prepaid country club membership or a prepaid personal insurance policy run through the business shouldn't count toward working capital any more than it should count toward EBITDA.
None of this is exotic. What's underappreciated is how much value moves through these definitions compared to how little attention they get relative to the headline purchase price.
2. The lookback period, and what seasonality does to it
The peg target itself is usually set as a trailing average, commonly twelve months, of the target's actual net working capital. That's a reasonable default for a business with roughly even revenue through the year. It's a bad default for a business with real seasonality, and a surprising number of lower middle-market targets have more seasonality than a quick look at the P&L suggests: a services business with a slow Q1, a distributor that stocks up ahead of a summer selling season, a software company whose renewals cluster in Q4.
A twelve-month trailing average smooths over that seasonality, which sounds like a feature until the closing date lands at a seasonal high or low point relative to the average. A buyer closing right after the target's seasonal receivables build will be comparing an inflated actual NWC against a smoothed target, and the seller collects a windfall in the true-up. Close right before that same seasonal build, and the buyer gets the windfall instead. Either way, the outcome is closer to a coin flip tied to the calendar than to the actual health of the business, unless the lookback period and the peg calculation account for the specific seasonal pattern of that specific target rather than defaulting to a generic trailing average.
3. Deferred revenue, specifically, in software and subscription businesses
This deserves its own section because it's the single biggest working capital fight in software and subscription deals, and it's rarely resolved cleanly by a generic NWC definition drafted for a manufacturing or services business.
A company that collects annual subscriptions upfront carries a deferred revenue balance that can be a large percentage of total current liabilities. Under a standard NWC definition, that liability reduces net working capital, which reduces the seller's apparent working capital position, which can trigger a payment from the seller to the buyer at true-up if actual NWC comes in below the peg. Sellers reasonably point out that deferred revenue isn't a cash obligation the way a payable is; the company already has the cash, and simply owes future service delivery, which costs far less than the deferred revenue balance implies. Buyers reasonably point out that deferred revenue is a real, GAAP-recognized liability, and ignoring it lets a seller who front-loads annual billing just ahead of a sale process show an artificially strong NWC position.
There isn't a universally correct answer here, which is exactly the point: it has to be negotiated explicitly, ideally addressed by name in the letter of intent rather than left to the definitive agreement's working capital schedule, where it becomes one more line item easy to gloss over under time pressure. A common middle ground treats deferred revenue at a discount, an estimate of the actual cost to deliver the remaining service obligation, rather than either the full GAAP balance or zero, but that discount rate is itself a negotiation, not a formula.
4. Estimated peg at signing, and what happens at the true-up
The purchase price at close is based on an estimated NWC figure, prepared by the seller (sometimes with buyer review) shortly before closing. The actual figure, calculated from the closing balance sheet, comes later, typically sixty to ninety days after close, and the difference triggers a payment in either direction. This mechanism is standard and not itself the problem. The problem is what happens when the two sides disagree on the actual figure, which is common enough that every well-drafted purchase agreement should specify the resolution process before it's needed, not after.
The usual path: the buyer prepares a closing statement, the seller has a defined window (often thirty days) to object, and unresolved disputes go to an independent accounting firm for binding resolution, with costs split based on how far each side's number was from the final result. Deals that skip specifying this process in detail, or that leave the dispute resolution mechanism vague, end up negotiating the process itself in the middle of a dispute over the number, which is a strictly worse position for both sides than having agreed on the referee before there was anything to referee.
5. What happens in the gap between signing and closing
Even with a clean definition and a fair lookback period, the actual NWC on the closing date is still something a seller has some ability to influence in the weeks between signing and close, particularly in deals with a longer gap for financing or regulatory approval. Slowing down collections, delaying a planned inventory purchase, or pushing a discretionary payable past the closing date are all within a seller's normal operating latitude and none of them are obviously bad faith individually. Collectively, over a few weeks, they can move the needle.
The practical defense isn't a legal one, it's operational: a buyer with diligence access during the gap period should actually look at AR aging and AP aging trends week over week, not just at signing and at close. A sudden deceleration in collections or a payables balance that's grown unusually large right before the closing date is a visible, checkable pattern, and catching it during the gap period is far cheaper than fighting about it after close.
A simplified worked example
None of the above is abstract once it's applied to real numbers. Below is a simplified version of how a target's NWC peg and true-up might actually be built, deliberately using a business with a modest deferred revenue balance to make the mechanics visible rather than the dollar amounts realistic.
| Component | 12-Month Trailing Average (Peg) | Actual at Close |
|---|---|---|
| Accounts receivable | $1,240,000 | $1,410,000 |
| Prepaid expenses (operating only) | $85,000 | $78,000 |
| Accounts payable | ($610,000) | ($540,000) |
| Accrued payroll & bonuses | ($195,000) | ($260,000) |
| Deferred revenue (at 40% delivery-cost discount) | ($310,000) | ($295,000) |
| Net working capital | $210,000 | $393,000 |
In this example, actual NWC at close exceeds the peg by $183,000, which the buyer owes the seller at true-up, since the business came with more working capital than the price assumed. Flip the AR and payables lines and the same mechanics produce a payment running the other direction. The formula never changes; what changes is which side benefits from a given definition, which is exactly why the definition is worth negotiating with the same attention as the purchase price multiple, not signed off as a formality on the way to the signature page.
What actually protects each side
A short, practical list, aimed at whichever side of the table is reading this:
- Get specific about the NWC definition, deferred revenue treatment above all, in the letter of intent, not just the definitive agreement. Renegotiating a definition after exclusivity has real leverage costs that negotiating it before signing does not.
- Ask for, and actually review, twelve to twenty-four months of monthly (not just annual) working capital detail before agreeing to a lookback period, specifically to check for seasonality the annual average would hide.
- Name the independent accountant, or at least the selection process, for dispute resolution in the agreement itself, before there's a dispute to resolve.
- For a buyer: track AR and AP aging weekly during the signing-to-close gap, not just at the two endpoints.
- For a seller: run the actual peg calculation, using the agreed definition, at least sixty days before your target closing date. Finding out at true-up that a boilerplate definition doesn't fit your business is the expensive way to learn it.
The working capital peg gets less attention than almost any other major deal term relative to how often it actually moves cash after close. Treat the definition with the same scrutiny as the multiple, because in a real sense, it's part of the price.