The Working Capital Math Nobody Shows You

Working capital is one of those topics where everybody nods along like they understand it until they're sitting across from a broker or a seller and realize they don't.

I see this constantly. A buyer will be weeks into a deal, deep in negotiations, and then the broker asks a simple question: "What's your net working capital peg?" And the buyer freezes. Not because they're dumb. Because nobody actually taught them how this works in practice.

The textbook definition is easy. The real-world application is where deals get complicated, negotiations stall, and buyers end up either overpaying or closing undercapitalized. So let's fix that.

One note before we start. This piece is written mostly from the buyer's seat, because that's where the questions usually come from. But if you're an owner thinking about selling, read the whole thing, then read the last section, which is written for you. Every dollar of working capital described below is a dollar that moves between your pocket and the buyer's at the closing table. It is one of the quietest ways money changes hands in a deal, and most sellers never see it coming.

What Working Capital Actually Is (And Why You're Buying It)

At its most basic level, net working capital is your current assets minus your current liabilities on the balance sheet. That's it. Accounts receivable, inventory, prepaid expenses on one side. Accounts payable, accrued expenses on the other. The difference is your net working capital.

Now here's the part that trips people up: when you buy a business, you buy it with working capital. This is standard in middle market M&A. The analogy I use is buying a car. If you buy a car and it comes with no gas, the car doesn't go anywhere. Working capital is the fuel the business needs to operate. Without it, you're sitting in the driver's seat on day one with no way to pay for the things the business needs to keep running.

That sounds obvious. It is not obvious to everyone involved in your deal. More on that in a minute.

Why You Set a Peg (And What It's Protecting You From)

Working capital is a moving target. It fluctuates constantly. Customers pay invoices at different times. You're paying vendors at different times. The actual net working capital number on any given day could be materially different from what it was last week.

So you set a target. That target is called the net working capital peg.

The purpose of the peg is simple: it prevents the seller from manipulating working capital before closing in a way that leaves you short.

Here's a real example of how that could happen. Say there's no peg in the deal. The seller, knowing they get to keep whatever cash is in the bank account at closing, calls up all their customers in the weeks before close. "Hey, any outstanding invoices you owe us? Go ahead and pay those now." The customers pay early. That cash lands in the seller's bank account. The seller walks away with it.

Now you step in as the buyer. Those accounts receivable that would normally be flowing in over the next 30, 60, 90 days? Gone. They were collected early. But all of the payables are still there. Rent is due. Payroll is Friday. Vendors need to be paid. And you don't have the incoming cash flow to cover it because the seller already collected it.

That's what the peg prevents. If you set a target for normalized net working capital and the seller under-delivers at closing, the purchase price gets reduced by the shortfall. If they over-deliver, you pay them the difference. It's a true-up mechanism designed to keep things neutral.

In theory, nobody should win or lose on the working capital adjustment. The peg should reflect reality. If it does, the seller delivers what was expected, there's no adjustment, and everyone moves on.

In practice, where you set that peg matters a lot.

How the Peg Gets Set (And Why You Shouldn't Do It Too Early)

The most common methodologies for setting a net working capital peg are a trailing 12-month average, a trailing 6-month average, or a trailing 3-month average of net working capital. Which one you use depends on the business.

And this is where I have a strong opinion: do not hard-code a specific working capital number in your LOI.

I see buyers get pushed into this all the time. The broker wants a number. The seller wants a number. Everyone wants certainty. I understand the impulse. But you're working with incomplete data pre-LOI, and locking yourself into a specific dollar amount based on one balance sheet snapshot is how you end up regretting it at closing.

Your quality of earnings provider is going to help you set the peg properly. They'll validate it through a proof of cash, normalize the AR and AP, and adjust for anything unusual. That's their job. Don't try to do it for them six weeks too early with limited information and good intentions.

What I recommend instead is keeping your LOI language broad. State that the business will be delivered with normalized net working capital and that a target will be established during financial due diligence.

If the broker is really pressing (and they will), here's a middle ground I've found that works: add a follow-up sentence along the lines of, "Based on our preliminary review of the most recent balance sheet, we estimate the working capital target will be approximately $X, subject to validation through financial due diligence."

You're giving them a directional number. You're showing you've done some homework. But you haven't boxed yourself in with a hard commitment you can't adjust once you have real data.

The Seasonality Problem

This is where trailing 12-month averages can get you into trouble.

Take a seasonal business. Think about any company where revenue spikes significantly during certain months and drops in others. If you're buying that business in October and closing at the end of the month, your working capital needs heading into November, December, January look very different than if you were closing in March heading into the busy season.

A trailing 12-month average captures the full cycle, which sounds fair. But depending on when you close relative to the seasonal pattern, the actual working capital at closing might be materially higher or lower than that average. And the direction of that gap determines whether the true-up works for you or against you.

This doesn't mean a trailing 12 is wrong. It means you need to think about whether it's the right methodology for this specific business and this specific closing timeline. Sometimes a trailing 6-month or 3-month average better reflects the actual working capital you'll need at the time you take over.

This is exactly why I push to keep the methodology flexible in the LOI. If you've already committed to trailing 12 and then your QoE provider says the last 6 months is a better picture, you've created a negotiation problem for yourself that didn't need to exist.

The Main Street Broker Problem

Here's something you'll run into if you're looking at deals in the $300K to $1M SDE range with main street brokers: a lot of them do not operate under the assumption that working capital comes with the business.

In middle market M&A, it's standard. The business comes with working capital. Full stop. But many main street brokers separate it out. They'll quote you a purchase price for the business and then say, "Oh, and then there's $200K in inventory and $100K in accounts receivable that you need to pay for on top of that."

That's not wrong. It's a different framework. They've been doing deals this way for 20 or 30 years and they're not going to change because you read an M&A textbook that says otherwise.

Your job is not to convince the broker that their framework is incorrect. You will lose that argument, and you'll burn the relationship in the process.

Your job is to figure out whether your total project cost (their purchase price plus the working capital items plus any additional cash you need to bring) works when you run the debt service. If it does, play their game. Use their language. Call it whatever they want to call it. Back into the numbers that work.

From the buyer's perspective, it's all purchase price. Their $1.5M plus $200K inventory plus $100K AR is your $1.8M all-in. The math is the same. The framing is different. Don't let the framing kill your deal.

One thing to be aware of: when the broker separates working capital from the purchase price, it does change the apparent multiple. A deal that looks like 3x on the broker's purchase price might be 3.6x when you add in the working capital they're carving out separately. That's not a trick. It's just a function of how they're presenting the numbers. You should always be looking at your all-in multiple, not theirs.

Post-Closing Liquidity Is a Different Question

This is the part that gets conflated with working capital, and it really shouldn't be.

The net working capital peg is an accounting construct. It's designed to make sure the business is delivered with the right amount of current assets and liabilities so you're not short-changed at closing. That's one question.

A separate question is: how much cash do I actually need on the balance sheet at closing to make sure I don't run into a cash crunch in my first 90 days?

These are related, but they're not the same analysis.

Even if the working capital peg is set correctly and the seller delivers exactly what was expected, you still need to think about your fixed monthly obligations. Payroll. Rent. Insurance. Utilities. Vendor payments. These costs hit your bank account on a predictable schedule regardless of how quickly your customers are paying you.

The gap between when cash goes out and when cash comes in is your cash conversion cycle. If it takes you 60 or 90 days on average to collect receivables, but payroll is every two weeks and rent is the first of the month, you need enough cash on hand to bridge that gap.

A conservative rule of thumb I use: look at your fixed monthly expenses and think about having enough excess cash at closing to cover those for a period roughly equal to your cash conversion cycle. If it takes 90 days to convert, you probably want about three months of cash for fixed expenses as a buffer. If it's 30 days, the number is lower.

Is that aggressive or conservative? It depends on the business. That's exactly why a quality of earnings provider is so valuable here. They can help you model the cash needs based on actual payment patterns and tell you where you're at risk.

The point is: don't assume that the working capital peg, by itself, means you have enough cash to operate. Those are two different questions, and you need answers to both.

The Seller Conversation You're Going to Have

One more thing, because it comes up in almost every deal.

At some point, if you take the position that working capital comes with the business (and you should), the seller is going to push back on accounts receivable. They will say some version of: "We sold those jobs. We did the work. Why do you get the receivables?"

It's a fair question. And you can try to explain the accounting. True-up mechanisms. Cash-free debt-free conventions. Normalized NWC targets.

Most sellers will tune out in about 15 seconds.

What actually works is making it concrete. "If I take over on Monday, I've got to make payroll on Friday. Your employees need to get paid. How do I pay them if the business doesn't come with the receivables that are flowing in to fund those obligations? The AR isn't a bonus for me. It's the gas in the tank that keeps your people employed and your business running."

That's the argument. Sellers care about their people. They care about the business continuing to operate. When you frame working capital as the thing that keeps the lights on and employees paid in week one, it stops feeling like you're trying to take something from them.

Because you're not. You're buying a running business. It needs to keep running.

If You're the Seller: The Same Math, From Your Side of the Table

Everything above is written for the buyer, and almost all of it is the buyer protecting himself. So here is why you, the seller, should care about every word of it: the working capital peg is one of the quietest ways money moves at the closing table, and most of the time it moves out of your proceeds. If you learn one new thing before you sell, learn this.

Start with the hard part. Working capital comes with the business. You are not keeping the receivables and the inventory on top of the price you negotiated. In a properly structured deal, the price assumes the business shows up running, with a normal amount of fuel in the tank. Back to the car: you agreed to sell a car that drives off the lot. You don't get to siphon the gas on the way out and still collect the full sticker price.

Now the part that works in your favor. The peg is not the buyer's weapon. It is the referee. Without an agreed target, a buyer can show up at closing and claim the business needs far more working capital than it really does, and chip your price down with nobody to stop him. A peg set off normalized, real numbers protects you from exactly that. Your job is not to fight the peg. Your job is to make sure it is set off a fair picture of how the business actually runs, and not off a cherry-picked low month that happens to favor the buyer.

Here is where it hits your wallet. If you deliver less working capital than the target, your price gets reduced, dollar for dollar. If you deliver more, you get paid for the difference. That true-up happens after you thought the number was settled, and it can move six figures. The methodology matters too. A trailing 12-month average, a 6-month, and a 3-month can produce very different targets, especially if your business is seasonal. Understand the target and the method before you sign, not after.

The biggest mistake we see sellers make is trying to win on working capital by draining the business before close. Collect every receivable early. Stretch the payables. Pull the cash out. It feels like found money. It is not. A well-drafted deal trues all of it back against you, so you don't actually keep it. You just create a fight, spend goodwill you will want later, and in the worst case you give the buyer a reason to walk. The cleanest path to your full price is boring: run the business normally, right up to the day you hand over the keys.

And when you feel that flash of "I did that work, why does the buyer get paid for it?", sit with it for a second, because the answer is the whole point of selling well. The receivables are what let the business make payroll the Friday after you leave. If they walk out the door with you, the buyer can't pay your people or your vendors in week one, and the company you spent a career building stumbles right out of the gate. The price already pays you for the work you did. The working capital is what keeps your name in good standing and your people employed after you're gone. For most owners we represent, that second part matters as much as the check.

This is exactly the kind of line item that is invisible until it costs you, and it is one of the first places we look when we represent a seller. We model your real working capital, normalize it, and make sure the peg is set off numbers that reflect how the business actually operates, so you are not handing back proceeds to an inflated target and you are not getting surprised by a downward adjustment on closing day.

The Bottom Line

Whether you are buying a business or selling the one you built, working capital is rarely the headline number, and it is almost always the one that quietly moves money at the closing table. We work both sides of that table at BayCoast. We help buyers structure and finance acquisitions, and we help founder-owners sell the companies they spent a career building. If you have a deal where this is in play, the time to talk is before the peg is set, not after.

Book a call with BayCoast, or reach me directly at drew@baycoastadvisors.com.