Setting a fair working capital peg before signing the LOI

The working capital peg sits at the heart of a clean LOI and closing. Get this number wrong at signature, and you’re either funding a seller’s cash grab or posting your own money as holdback collateral for someone else’s balance sheet inefficiency. Unlike EBITDA, which normalizes earnings away, the peg locks in a target cash position at signing—and every dollar above or below it flows between buyer and seller at close. This isn’t a back-of-napkin number. It’s a calculated fair value that reflects how much working capital the business actually needs to run, and it belongs in your LOI before anyone’s legal team runs up a six-figure bill arguing about it post-LOI.

What a Working Capital Peg Really Does

The peg is an agreed-upon amount of working capital—typically stated in days sales outstanding (DSO), days payable outstanding (DPO), and days inventory outstanding (DIO)—that the seller will deliver at closing. If actual working capital at close exceeds the peg, the buyer pays the seller for the surplus. If it falls short, the seller pays the buyer the shortfall. This mechanism exists because working capital changes hands at closing: the buyer inherits the cash conversion cycle, and the seller doesn’t get to carry receivables or inventory forward.

Without a peg, disputes are inevitable. A seller might drain accounts receivable aggressively in the final weeks before close to inflate their exit proceeds. A buyer might claim the working capital position has deteriorated due to post-LOI mismanagement and demand a credit at close. The peg eliminates this ambiguity by establishing a baseline, measured in concrete working capital dollars, that both parties agree the business should maintain on day one under new ownership.

Calculating the Components: DSO, DPO, and DIO

Start with the three building blocks. These metrics come directly from the seller’s normalized financial statements—not speculative forecasts, but trailing twelve months (TTM) or an average of the last 24 months.

Days Sales Outstanding (DSO) measures how long it takes the business to collect cash from customers after a sale. The formula is simple:

DSO = (Accounts Receivable / Revenue) × 365

For a staffing or business services company with a DSO of 45 days, the business is carrying roughly 45 days’ worth of revenue on its books as unpaid invoices. If monthly revenue is $500,000, that’s roughly $750,000 in accounts receivable sitting on the balance sheet. When you acquire that business, you inherit those receivables—and the cash you must wait to collect.

Days Payable Outstanding (DPO) measures how long the business takes to pay its suppliers after receiving an invoice.

DPO = (Accounts Payable / Cost of Goods Sold or Operating Expenses) × 365

A higher DPO is favorable for cash flow—it means the business holds onto its cash longer. If DPO is 60 days, the business pays suppliers nearly two months after incurring the obligation. That’s interest-free working capital courtesy of suppliers.

Days Inventory Outstanding (DIO) applies mainly to product-based businesses, but some service businesses carry inventory (consumables, materials). It measures how long inventory sits before sale:

DIO = (Inventory / COGS) × 365

For a pure-service business with no inventory, DIO is zero. Skip it.

Building the Peg: A Worked Example

Say you’re acquiring a light industrial staffing firm. You’ve normalized the seller’s TTM financials and extracted these working capital metrics:

• DSO: 38 days (customers typically pay within 35–40 days)
• DPO: 25 days (the firm pays vendors within about 25 days)
• DIO: 0 days (no inventory)
• Normalized annual revenue: $8.4 million
• Normalized cost of operations: $7.2 million

Now calculate working capital in dollars. Accounts Receivable on day one will be approximately (Revenue / 365) × DSO:

AR = ($8,400,000 / 365) × 38 = $873,425

Accounts Payable will be approximately (Operating Expenses / 365) × DPO:

AP = ($7,200,000 / 365) × 25 = $493,151

Net working capital = $873,425 − $493,151 = $380,274

That $380,274 is your peg. At closing, if the actual working capital (calculated the same way) is $395,000, the seller owes you $14,726. If it’s $360,000, you owe the seller $20,274.

Adjusting for One-Time and Seasonal Factors

Real businesses aren’t perfectly flat month-to-month. A consumer goods distributor might have a DSO spike every November as holiday orders roll in. A tax services firm might show wild swings in AP between tax season peaks and summer troughs. A legitimate peg accounts for these patterns without letting the seller hide bad discipline under the guise of “seasonality.”

The safest approach is to use a 24-month average rather than a single quarter. If the most recent quarter is a seasonal outlier, the peg should reflect the normalized pattern. Some deals also build in a seasonal adjustment mechanism—specifying that if close falls in a high-inventory month, the peg adjusts upward by X% to reflect normal seasonal build. Be explicit in the LOI about how this is calculated and when it applies.

One critical gotcha: non-recurring items. If the seller moved a large customer payable to the next year or prepaid rent to harvest a cash benefit, that distorts DPO and will make your actual working capital at close look worse than the peg suggests. Review the seller’s last three quarters of A/P aging and DSO by customer segment to catch this.

Setting the Peg: Market vs. Optimized

You now have two versions of the working capital peg:

• Market peg: Based on the business as the seller currently operates it—actual DSO, DPO, and DIO from the trailing financials.
• Optimized peg: Based on how you believe the business can and should operate under your ownership, with faster collections, better terms, or both.

The LOI should specify the market peg. The optimized peg is your internal target for post-acquisition operations, but it’s not the working capital adjustment mechanism. Why? Because imposing an optimized peg at close gives the seller every incentive to degrade the business before handoff—drain receivables, stretch payables, build inventory—knowing they’ll pay you a credit if they hit the lower optimized number. The market peg reflects reality as of signing and closing, reducing that perverse incentive.

That said, if the current peg seems egregiously high—DSO of 90 days in an industry where 45 is standard—you may negotiate a phased approach or post-close working capital targets. But that’s a renegotiation of the economics, not the peg. It belongs in a separate earn-out or milestone schedule, not the baseline adjustment.

The Minimum and Maximum Threshold in the LOI

Most LOIs include a collar—a minimum and maximum working capital threshold beyond which neither party is responsible. A typical collar might state: “Working capital will not be adjusted if the closing working capital differs from the peg by less than $25,000.” This avoids nickel-and-diming and keeps both parties from obsessing over timing swings of a week or two.

Set this threshold as a percentage of deal value or a fixed dollar amount—typically 0.5% to 1% of purchase price for smaller deals. If your deal is $5 million, a $25,000 collar (0.5%) is reasonable. A $2 million deal might use $10,000. The idea is to absorb minor timing and estimation error without creating an adjustment mechanism.

Cash at Close vs. Working Capital Peg

Don’t confuse working capital peg with cash at close. The peg measures operating working capital (AR + Inventory − AP). Cash is separate. The LOI typically specifies target cash, which also adjusts at close. Cash in the bank is treated differently—it usually flows dollar-for-dollar at purchase price, with no adjustment. Working capital is the operating portion of the balance sheet that funds day-to-day operations; cash is the financial cushion the buyer chooses to inherit (or not).

An LOI might read: “Purchase price is $5M, with a working capital peg of $400,000 and target cash of $100,000. At close, closing working capital and cash balances are measured, and purchase price is adjusted dollar-for-dollar if actual differs from target.”

Real-World Edge Cases

Imagine a situation where the seller has extended terms to win a large customer just before close—DSO spikes to 55 days because a new anchor account pays in 60 days rather than 30. If this is a permanent change in the customer base, it’s not an edge case; the peg should reflect it. But if it’s a one-time win and you know the customer will normalize, document that customer in the working capital schedules and flag it for post-close monitoring.

Or consider a business where the seller has deferred maintenance on payables—not paying certain vendors or stretching truly agreed terms beyond reason. This inflates DPO artificially and makes the peg look better than operations can sustain. During your financial due diligence, scrutinize the A/P aging for “aged payables” and ask about relationships with key vendors. If payables are strained, adjust your estimate of sustainable DPO downward before setting the peg.

A third case: a business that switches to a new bank or accounting system just before close. Timing of AR/AP recognition can shift by a week or two depending on how the system records transaction dates. Be specific in the LOI about how working capital is measured—on what date, using which GL, using which accounting treatment for accruals and deferrals.

Setting the Peg in the LOI: Language That Matters

Your LOI should include these specifics:

• Definition: “Working capital means current assets (exclusive of cash and debt) minus current liabilities, calculated in accordance with GAAP and consistent with how Seller calculated it in the historical financials provided.”
• Peg amount: “The target working capital is $[X], calculated as [DSO] days, [DPO] days, [DIO] days, applied to normalized annual financials as of [measurement date].”
• Measurement: “Working capital will be calculated using the same methodology, accounts, and GL mappings used to prepare Seller’s TTM financials.”
• Timing: “Closing working capital will be measured as of 11:59 p.m. on the closing date, and settlement will occur within [X] days of receipt of final closing statement.”
• Collar: “No adjustment shall be made if closing working capital differs from target by less than $[X].”

Vague language (“working capital will be in line with historical levels,” “adequate to operate the business”) invites post-close disputes. Be precise. If the metrics-based approach seems too rigid, you can add a sentence allowing both parties to agree to a final working capital measurement within 30 days of close if they disagree on the calculation—but the methodology is locked down in the LOI.

Using Outsourcing Processing to Organize Your Peg

Once you’ve calculated your peg, organizing it alongside normalized EBITDA and other deal metrics in a single platform speeds the LOI drafting and helps you spot inconsistencies. Outsourcing Processing organizes normalized working capital data so you can track the peg, validate it against the seller’s GL, and ensure it’s consistent with the normalized financials you’re using to calculate purchase price. The platform doesn’t advise on what the peg should be—that’s your deal team’s call—but it helps you calculate it accurately and audit the inputs before you sign.

Frequently Asked Questions

Why should I set the working capital peg before signing the LOI and not wait until closing?

Because disagreements about working capital are among the most common post-close disputes, especially in smaller deals without a full Quality of Earnings engagement. Locking the peg, calculation methodology, and measurement date into the LOI eliminates ambiguity and prevents the seller from having incentive to degrade the balance sheet between signature and close. If the peg is left vague, you risk disputes that delay closing or require escrow.

Should my peg reflect how the business operates today or how I plan to operate it post-acquisition?

Your LOI peg should reflect the market baseline—how the business operates today, based on trailing financials. Your optimized target is separate and belongs in your post-acquisition plan or integration timeline. Using an optimized peg creates perverse incentives for the seller to degrade the business before close to hit a lower number. The market peg is the fairest measure of what you’re actually buying.

What’s a reasonable working capital collar, and how do I justify it to the seller?

A collar of 0.5% to 1% of deal value is typical for smaller acquisitions. It absorbs minor timing swings and estimation differences without creating a false sense of precision. If your deal is $3 million, a $15,000 collar is reasonable; anything above $50,000 requires direct agreement. The justification is simple: the peg is an estimate, working capital fluctuates week-to-week, and both parties benefit from avoiding disputes over immaterial variance.

How do I handle seasonality when setting the peg?

Use a 24-month average rather than a single quarter to smooth seasonal spikes. If your close date falls in a season with predictably higher working capital (e.g., pre-holiday inventory), the LOI can include a seasonal adjustment formula agreed upfront. Document this explicitly in the LOI and agree on how the adjustment is calculated and verified. This prevents surprise swings at close.

What if the seller’s accounts payable seem artificially stretched just before the LOI is signed?

Flag this during financial due diligence and document vendor payment terms from actual invoices and payment records. If DPO is being inflated by deferred payables or bad relationships, you should adjust your estimate of sustainable DPO downward before proposing the peg to the seller. This reflects the true operating reality, not short-term cash hoarding that you’ll inherit as the buyer.

Should I include debt payoff or earnout timing in the working capital peg calculation?

No. The working capital peg measures operating assets and liabilities—AR, inventory, and AP. Debt payoff is a separate financing decision at close, and earnouts are incentive payments, not operating working capital. Keep the peg focused on what the business needs operationally to run, and handle debt and earnout mechanics in separate sections of the purchase agreement.

The working capital peg is one of the few deal mechanics you can lock down cleanly before signing the LOI if you invest time in the math upfront. A fair peg, based on normalized metrics from auditable financials, costs you maybe a day or two of diligence legwork and prevents weeks of post-close argument. The effort pays for itself many times over. Set the peg, state the methodology in plain language, and move forward confident that both parties understand what’s being bought and what it costs at close.

This article is educational and does not constitute M&A, investment, or accounting advice — confirm findings with a licensed CPA or M&A advisor before making an offer.

This article is educational and does not constitute M&A, investment, or accounting advice — confirm findings with a licensed CPA or M&A advisor before making an offer.

This is exactly the kind of adjustment IncomeReady keeps organized and ready for your review.