Most acquisition proposals include a working capital peg—a target baseline for receivables, inventory, and payables that the buyer expects to find at close. The seller funds the gap if assets fall below it; the buyer funds the gap if they exceed it. Straightforward on paper. In practice, buyers routinely underestimate what “normal” working capital looks like once they own the business, because they’re modeling the target based on seller-provided financials that do not yet reflect the operational changes acquisition itself triggers. The disconnect costs time, cash, and post-close credibility.
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Why Historical Financials Mislead on Working Capital Reality
The financials used to set the working capital peg are usually audited or compiled based on the seller’s last 12–24 months of operation. Those numbers are clean—they reflect how the seller managed the business: payment terms, collections discipline, inventory turns, supplier arrangements. On day one of ownership, none of that remains static.
Buyers inherit operational friction that doesn’t show up in a balance sheet. Assume you’re buying a small contract services firm with accounts receivable of $180K on a trailing twelve-month revenue base of $1.2M. The seller’s DSO (days sales outstanding) was 45 days. That’s tight—the seller knows the customers and doesn’t wait. Your underwriting assumes you’ll maintain that 45-day DSO and target a working capital peg of $150K in AR (1.2M ÷ 365 × 45). But on day 31 of ownership, collections slow. New invoicing systems don’t integrate cleanly. Your credit team isn’t yet embedded. Customer relationships shift slightly because the seller is gone. AR creeps to $210K within 90 days. You’ve now funded an extra $60K of working capital that wasn’t in your model—and nobody’s balance sheet was “wrong.” The seller’s DSO was real; your operational reality is different.
The Most Commonly Underestimated Line Items
Accounts Receivable
Buyers almost always assume they can maintain or improve the seller’s collection velocity. That assumption breaks three ways: (1) customer concentration changes if a large customer is nervous post-close, (2) invoicing quality drops during systems transition, and (3) the personal relationship the seller had with paying customers is gone. Even a 5–10 day DSO increase translates to 1–2% of revenue locked up in extra AR. For a $2M business, that’s $20K–40K of unanticipated working capital.
Inventory
If the target business carries inventory, the buyer’s supply chain is now the buyer’s supply chain. Seller-managed just-in-time procurement and vendor terms often don’t transfer smoothly. New suppliers demand shorter payment windows. Inventory levels creep higher during the onboarding phase as the buyer de-risks stock-outs. A 10–15% bump in inventory levels is common in the first 180 days post-close—easily $50K–150K for a mid-market business.
Accounts Payable
This is where buyers create their own trap. Eager to maintain supplier relationships and avoid disruption, they often agree to honor the seller’s payment terms—or, worse, tighten them to improve their own cash position. If the seller paid in 60 days and the buyer shifts to 30, working capital suddenly includes cash the buyer no longer has. Conversely, if the buyer extends terms (paying in 90 days instead of 60), AP grows, but it often grows slower than the buyer expects because suppliers recognize a change of ownership and demand faster payment or COD terms until trust is rebuilt.
A Concrete Example: Setting and Resetting the Peg
Consider a light manufacturing firm purchased for $3.5M EBITDA add-backs. Trailing twelve-month revenue is $4.8M. The seller’s balance sheet, as of close, shows:
- Accounts Receivable: $320K (27 DSO)
- Inventory: $410K
- Accounts Payable: $(185K) (43 DPO)
- Net Working Capital (NWC) Target: $545K
The buyer and seller agree on a $545K working capital peg. But within 120 days of close, the buyer’s operations team reports:
- AR has grown to $380K because a key customer (15% of revenue) is contesting invoices and paying 45 days instead of 27.
- Inventory has grown to $490K because the buyer retained a third supplier (higher cost, same volume) until new cost negotiations closed, and also purchased buffer stock during supplier onboarding.
- AP has dropped to $155K because one major supplier demanded net-15 terms post-close instead of net-43.
- Adjusted NWC: $715K (a $170K overage)
The working capital true-up is due to the buyer, not from poor underwriting but from operational reality. The buyer should have built a 15–25% buffer into the initial estimate, especially around AR and inventory transition risk. That buffer shows up in either higher purchase price or lower working capital peg—both of which are negotiable if flagged before LOI.
How to Model Working Capital More Accurately
Start with Transaction-Specific Sensitivities
Don’t use historical DSO/DPO/inventory turns as gospel. Instead, ask: (1) Which customer relationships are at risk if the seller departs? (2) How will your systems and processes differ from the seller’s? (3) Are you changing any payment terms or supplier relationships? (4) What’s your working capital policy for cash management? Build a model that adjusts for each. If a customer represents 20%+ of revenue and the seller has the relationship, add 10–15 days to DSO during transition. If inventory is on JIT and you’re moving to a decentralized system, add 5–10% to stock levels for the first 12 months.
Project a Post-Close Roll-Forward
Many buyers set the peg on day zero but don’t model day 30, 60, 90, and 180. Work through a 180-day cash projection that assumes operational friction—longer AR collection, higher inventory, tighter payables—and back into a revised working capital target for month 6. That becomes your “normalized” baseline. The difference between day-zero and day-180 is your transition risk and the amount you may need to fund.
Align the Peg to Your Operating Model, Not the Seller’s
If the seller was owner-operated and you’re bringing in a finance team, AR collection will change. If the seller had one warehouse and you’re moving to three, inventory footprint changes. If you’re consolidating vendors, payables terms change. The peg should reflect your intended operating model 120 days out, not the seller’s historical run rate. Document these assumptions in the SPA and tie the working capital calculation to them.
A Practical Checklist Before Agreeing to the Peg
- Customer concentration: Do your top 5 customers represent >40% of revenue? Model a 10–20 day DSO increase.
- Systems transition: Will you integrate ERPs, accounting software, or invoicing? Budget 60–90 days of collection friction.
- Inventory model: Are you centralizing or decentralizing stock? Increasing safety stock? Add 5–15% to peg.
- Supplier risk: How many suppliers represent >10% of COGS? Budget for renegotiation delays and potential COD or net-15 demand.
- Post-close cash policy: Will you hold more cash than the seller did for working capital buffer? That changes NWC needs.
Frequently Asked Questions
Should we build a working capital buffer into our peg, or keep it tight and adjust post-close?
A tight peg minimizes day-one cash outlay to the seller but guarantees a working capital true-up in your favor post-close if operations improve. A padded peg costs more at signing but avoids funding surprises and post-close disputes. Most buyers favor a peg pitched 10–20% above historical NWC if there’s material transition risk (systems, key customer relationships, inventory model change). Document your assumptions in the SPA so the true-up calculation is mechanical, not interpretive.
What’s the difference between working capital peg and working capital adjustment?
The peg is the target NWC balance agreed pre-close, based on historical financials and underwriting assumptions. The adjustment is the true-up calculation done post-close (usually 60–120 days after close) that compares actual NWC to the peg. If actual NWC is higher, the buyer pays the seller. If it’s lower, the seller pays the buyer. The SPA specifies both the calculation methodology and any caps, collars, or thresholds.
How do we handle working capital if we’re changing the operating model significantly?
Disclose the changes in the LOI and SPA and set the peg to reflect your post-acquisition model, not the seller’s historical run. If you’re centralizing from three warehouses to one, inventory will drop—but only after integration. The peg should assume your day-180 baseline, not day-zero cleanup. This protects both buyer and seller from fighting over whether an NWC overage is “normal transition” or “seller mismanagement.”
Can we use normalized EBITDA calculation tools to stress-test working capital assumptions?
Yes. Platforms like Outsourcing Processing organize and calculate normalized EBITDA and working capital data for the buyer’s own review—helping you model sensitivities and cross-check ASO, DPO, and inventory turns against your own operational assumptions. That’s a faster first pass than a full Quality of Earnings, especially for smaller deals under $10M. For larger or more complex acquisitions with material working capital risk, a traditional Quality of Earnings engagement with a licensed CPA firm is still warranted.
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.
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