If you’ve ever sat at a closing table, you know the deal isn’t actually done when the purchase price is agreed upon. The final check usually looks quite different from the headline number, and the primary culprit is the adjustment mechanism, specifically the working capital peg.
In the high-stakes world of tech acquisitions, where business models shift rapidly from hardware to SaaS and subscription revenue, working capital in M&A is often the most contentious part of the purchase agreement. If you don’t get the math right, you’re either leaving significant money on the table or inheriting a massive, hidden liability that cripples your first-quarter cash flow.
At its core, what is target working capital? It’s a baseline number intended to represent the normal amount of capital required to run the business on a day-to-day basis.
When a buyer purchases a company, they expect to step into a business that has enough cash, receivables, and inventory to keep the operations running smoothly without having to immediately inject fresh capital. The target working capital acts as a contractual benchmark. If the business is delivered with more than that amount, the seller is typically compensated. If it’s delivered with less, the purchase price is adjusted downward to account for the deficit. This process, often referred to as the net working capital adjustment M&A process, is the financial “true-up” that determines the actual enterprise value transferred at closing.
Think of the net working capital peg as a financial anchor. It defines the point of indifference. If the business is sold with the exact amount of working capital specified in the working capital peg, no cash moves between buyer and seller regarding the adjustment.
In working capital M&A negotiations, the parties engage in a tug-of-war over what constitutes a “normal” level. If a seller insists on a high peg, they are essentially arguing that the company is highly efficient and requires minimal cash to maintain its current trajectory. If the buyer pushes for a low peg, they are attempting to mitigate the risk of overpaying for assets that might be temporarily inflated by aggressive billing or delayed vendor payments.
The target working capital calculation is typically derived from a trailing 12-month (TTM) average. By looking at monthly snapshots of current assets minus current liabilities, you effectively smooth out seasonal volatility and operational spikes.
This average is the starting point for your working capital target. However, in the tech sector, you have to be meticulous. You must adjust for non-recurring items, one-time integration costs, or accounting anomalies that might skew the raw numbers. When calculating a working capital target M&A, both sides usually aim to strip away any noise that doesn’t represent the true, ongoing operational state of the business.
Buyers utilize working capital in M&A transactions to prevent leakage and ensure operational continuity. Imagine a scenario where a seller stops paying their server vendors or pulls back on R&D spending to inflate their cash position right before closing. Without a robust working capital peg M&A mechanism, the buyer would inherit a hollowed-out company the next day, struggling to meet customer demands.
By setting a strict M&A working capital target, the buyer forces the seller to maintain the status quo. It is effectively an insurance policy. If the seller wants to walk away with more cash, they must ensure the business is left in a stable, fully operational state that matches the financial representations made during due diligence. This discipline ensures that the buyer isn’t effectively funding the seller’s final months of operation through an artificially inflated purchase price.
Let’s look at a practical working capital peg example to see how this shifts cash at the finish line.
Suppose you are acquiring a mid-sized SaaS platform. Through the due diligence process, the working capital peg is set at $1,000,000. On the closing date, the parties conduct a final count of current assets (like trade receivables and prepaid expenses) minus current liabilities (like accounts payable and accrued expenses). You find that the actual net working capital is $800,000.
Because the business was delivered with $200,000 less than the agreed target working capital, the buyer is owed a $200,000 adjustment. This amount is typically deducted from the final purchase price or held back from an escrow account. This peg working capital adjustment keeps the seller accountable for their financial management right up until the deal is funded. If the target were too high, the buyer would suffer; if it were too low, the seller would lose out. The peg represents the objective middle ground that aligns incentives.
Negotiating working capital in M&A for tech and internet-based businesses is uniquely complex because these companies often operate with “negative” working capital. Since customers pay for annual subscriptions in advance, that cash shows up as deferred revenue, a significant liability on the balance sheet.
When you are assessing working capital software companies, the traditional accounting definition of “current assets minus current liabilities” can be deeply misleading. Buyers often negotiate to exclude specific deferred revenue items from the target working capital calculation to ensure the numbers reflect the actual cash-flow health of the business rather than accounting distortions caused by high-growth booking cycles. Failure to adjust for these nuances in net working capital M&A can lead to massive disputes post-closing.
You must also consider the excluded items list. In tech, items like cash, debt, and certain tax liabilities are typically excluded from the working capital calculation to ensure they are handled through separate mechanisms, such as the purchase price payment or debt payoff at closing. By ring-fencing these items, you prevent double-counting and ensure that the working capital target remains focused on purely operational assets and liabilities.
Mastering the working capital peg is not just an accounting exercise; it is a fundamental pillar of deal strategy. Whether you are a founder preparing for a liquidity event or a strategic buyer performing deep due diligence, the net working capital target is the terrain where the ultimate value of the transaction is often decided. Do not treat this section of the purchase agreement as a boilerplate afterthought. Instead, focus on the underlying operational reality to ensure the price you agree to is the price you actually pay. By being rigorous about the data, you protect the deal’s integrity and ensure a smoother integration.
In professional practice, they are used interchangeably. The “peg” is the negotiated numerical value, and the “target” is the benchmark used for the final adjustment calculation at closing.
Tech firms frequently have significant deferred revenue balances. Because this is treated as a liability in working capital M&A, it requires specialized treatment during the negotiation of the working capital target to prevent the buyer from paying twice for the same revenue.
If the company is delivered with more working capital than the working capital peg, the buyer typically pays the seller the difference in cash. It is a symmetrical mechanism.
Clearly define the specific line items included in the net working capital adjustment m&a in your Letter of Intent (LOI). The more precise you are at the start regarding what is included or excluded, the fewer headaches you will encounter when reconciling the final balance sheet.
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