Working Capital Adjustment (Working Capital Peg)

A buyer that values a business on a multiple of earnings, such as seller's discretionary earnings or EBITDA, assumes it will receive the business with enough receivables, inventory and prepaid expenses, net of payables, to keep operating without injecting more cash. That normal level is the working capital peg, sometimes called the target. If the seller collects receivables aggressively, runs down inventory or delays paying suppliers before closing, the buyer gets less than it priced. If the seller leaves extra inventory behind, the buyer gets more.

The adjustment corrects both. If closing working capital is below the peg, the price goes down by the shortfall; if it is above, the price goes up by the excess. Many share purchases include one, especially deals priced on a cash-free, debt-free basis, and it is common in asset deals where the buyer takes over receivables and payables. The mechanics live in the share purchase agreement or asset purchase agreement.

A working capital adjustment usually sits inside a cash-free, debt-free price. The headline price is an enterprise value for the operating business. At closing it is converted into the amount actually paid for the shares:

The seller is credited with cash and pays off debt, so the buyer pays only for the operating business. The definitions must not overlap: an item counted as debt has to be excluded from working capital, or one side is credited twice. Customer deposits and deferred revenue are a common battleground. A buyer argues they are debt-like because it must deliver the work without receiving the cash; a seller argues they are an ordinary part of working capital that was already reflected in the peg.

The peg should represent a normal level of working capital for the business, not a negotiated number:

• Trailing average. Pegs are commonly based on an average of month-end balances, often over the last 12 months, which smooths out short-term swings.
• Seasonality. A landscaper or a retailer can show very different balances in March and November. An annual average, or a peg that varies by closing month, avoids a windfall for whichever side the closing date favours.
• Normalization. One-time items, such as an unusual prepayment or a large bad debt, are removed so the peg reflects ordinary operations.
• Consistent accounting. Closing working capital must be calculated using the same policies that produced the peg, with any agreed exceptions listed. A change in the inventory obsolescence reserve or the bad debt allowance can move the result by tens of thousands of dollars.
• Collar. Some agreements set a band around the peg within which no adjustment is made, so small differences do not become disputes.

The method for setting the peg belongs in the letter of intent, before either side knows which number helps it, and a seller should test any proposed figure against its own monthly balance sheets. Lamba Law's LOI term sheet builder produces a plain-language outline of price and structure where that method can be recorded, and our guide to negotiating a letter of intent as a seller covers the seller's side of that negotiation.

Final numbers are not known on closing day, so the adjustment runs in steps:

1. Estimated closing statement. Shortly before closing, the seller delivers an estimate of closing working capital, cash and debt, and the price paid at closing reflects it.
2. Final closing statement. Within a fixed period after closing, the buyer, which now controls the books, prepares the final statement.
3. Review. The seller gets access to the books and working papers and a set window to object to specific items; anything still disputed is commonly referred to an independent accounting firm, whose decision is limited to those items.
4. Payment. The difference between the estimate and the final figure is paid by whichever side owes it.

A dedicated purchase price holdback or escrow for the true-up keeps the adjustment from competing with indemnity claims. The true-up is a price adjustment, not a damages claim, so it is usually kept outside the indemnity baskets and caps. An adjustment based on working capital at closing is also different from an earn-out, which depends on how the business performs after closing.

Smaller Ontario asset purchases often handle the same issue more simply. Rather than a full working capital adjustment, the agreement sets a price for equipment and goodwill and adds inventory at cost, based on a joint count on or just before closing. Receivables are frequently excluded and collected by the seller, the seller pays its own payables, and the buyer receives a credit for customer deposits on orders it will have to fill.

Inventory counts need rules: who attends, how damaged or obsolete stock is treated, whether cost means the seller's actual cost or current supplier pricing, and a ceiling so the seller cannot stock up before closing at the buyer's expense. Where the buyer does take receivables and payables, a conventional peg and true-up works for an asset deal too. Either way, the final amounts for inventory and the other assets flow into the purchase price allocation for tax.

Hamid Rezaei agrees to buy all the shares of an Oakville industrial fasteners distributor from its founder, Lucy Tran, for an enterprise value of $4,000,000 on a cash-free, debt-free basis. The peg is $650,000, the average of the last 12 month-end balance sheets, with no collar. Net working capital excludes cash, bank debt, income taxes and the shareholder loan.

At closing, the company owes $500,000 to its bank and $120,000 to Lucy on her shareholder loan, both repaid from the proceeds, and holds $80,000 of cash. Lucy's estimate shows working capital of $610,000, a $40,000 shortfall. Hamid pays $4,000,000, less $620,000 of debt, plus $80,000 of cash, less the $40,000 shortfall: $3,420,000, of which $100,000 goes into an adjustment escrow.

Seventy-five days later, Hamid's final statement shows working capital of $575,000. Lucy objects to a $35,000 write-down of slow-moving inventory that the company's historical policies would never have recorded. The independent accountant sides with Lucy on $25,000 and with Hamid on $10,000, fixing working capital at $600,000. Lucy owes a further $10,000, paid from the escrow, and the remaining $90,000 is released to her.