How a working capital peg is set, with a Gaston County example

Owners usually hear about the working capital peg as a single number in a letter of intent: "the purchase price assumes $2.7 million of net working capital at closing." That number was calculated, and the calculation contains choices. Walking through one example, line by line, is the fastest way to see which of those choices move money and which ones are worth arguing about.

The company below is illustrative, not a real transaction: a Gaston County technical fabrics producer with about $14 million of revenue, a filtration customer that orders heavily ahead of spring, and the long-tenured workforce and older owned building typical of Gastonia manufacturers.

Step one: agree what counts before counting anything

Net working capital in a purchase agreement is a defined term, and the definition decides the number more than the arithmetic does. The usual starting point is:

• In: trade receivables net of a bad-debt reserve, inventory net of an obsolescence reserve, and prepaid expenses.
• Out, as a reduction: trade payables and accrued operating expenses.
• Excluded entirely: cash, funded debt, and income taxes, because the deal is priced cash-free and debt-free.

The arguments live in the gray items. Accrued paid time off, invoices for equipment already delivered but unpaid, and the current portion of an equipment loan can each be treated as working capital or as debt. Every item treated as debt comes off the price dollar for dollar; every item treated as working capital moves the peg instead. Our earlier post on the working capital target covers several more of these, and they are worth settling in the letter of intent, as the LOI FAQ explains.

Step two: the trailing twelve months

With the definition fixed, the buyer measures working capital at each month-end for the last twelve months. For the illustrative plant:

• October to December: $2.6M, $2.5M, $2.4M
• January to March: $2.9M, $3.1M, $3.0M
• April to June: $2.8M, $2.7M, $2.6M
• July to September: $2.3M, $2.5M, $2.7M

The twelve months add to $32.1M, a simple average of about $2.68M. A buyer who stops here proposes a peg near $2.7M, and many sellers accept it because it looks like their own history.

Step three: normalize the months that were not normal

A simple average treats every month as representative. Two of these were not.

The stockpile. In January the company bought about $300,000 of extra fiber ahead of a supplier's announced price increase, and that inventory sat on the books through March. It inflated three month-ends by $300,000 each. Removing it lowers the average by $75,000, because $900,000 spread over twelve months is $75,000.

The disputed invoice. From April through July a customer withheld about $200,000 during a quality dispute that was later resolved and paid. Receivables ran $200,000 high for four months. Removing it lowers the average by roughly $67,000.

The normalized peg is about $2.53M, roughly $140,000 below the simple average. That $140,000 is not a rounding difference. It is money the seller would otherwise deliver to the buyer at closing, and the evidence for each adjustment is a purchase order, a price-increase letter, and a dispute file the company already has.

Step four: the closing month still matters

Even a well-set peg is compared with actual working capital on the closing date, and this company swings by $800,000 across the year. Against a $2.53M peg:

• A closing at the end of July, a low month at $2.3M, produces a shortfall of about $230,000 and a lower final price.
• A closing at the end of February, a high month at $3.1M, delivers about $570,000 more than the peg, which only helps the seller if the adjustment runs in both directions.

Two protections are worth asking for. The first is a two-way adjustment, so excess working capital is paid for rather than surrendered. The second, for a business this seasonal, is a peg that varies by closing month, or a closing date chosen with the swing in mind. Our year-end timing post covers how a physical count near closing tightens the measurement.

Step five: the true-up after closing

At closing the parties use an estimated balance sheet. Some weeks or months later the buyer prepares the final closing statement, the seller reviews it, and differences go to an independent accountant if the two sides cannot agree. Many agreements also include a small band in which no adjustment is made at all, so neither side argues over trivial amounts. The definition, the review period, and the dispute mechanism are all drafting choices, and each belongs in front of your transaction attorney and CPA before the agreement is signed.

Why SBA and asset-sale buyers watch this closely

A buyer financing the deal with an SBA loan faces a lender that, under SOP 50 10 8.1, has to analyze whether the business has adequate working capital for the next twelve months, and that can fold working capital into the loan request. A thin closing balance sheet becomes the buyer's financing problem, which is why these buyers push for a higher peg. In an asset sale, receivables and inventory are also allocated separately on IRS Form 8594, where receivables fall in Class III and inventory in Class IV, so the balances delivered flow straight into the tax allocation both sides file.

What to do before a letter of intent

Pull month-end balance sheets for the last 24 months, not 12, so seasonality is visible. List every unusual month and the document that explains it. Ask your CPA to calculate a peg under your own definition before the buyer proposes one. The working capital FAQ summarizes the mechanics, and our textiles and technical fabrics page covers what else buyers of Gaston County specialty producers examine. For a confidential read on your own numbers, call (704) 343-6770.