The Working Capital Mechanism at Close

The Architecture of the Working Capital Peg

The working capital mechanism exists to ensure that a business is delivered to the acquirer with a sufficient level of current assets to fund its immediate operational obligations. At the heart of this process is the 'peg', a benchmark figure representing the normal working capital requirement of the target. Value is adjusted upward if the actual working capital at close exceeds the peg, and downward if it falls short. This prevents a seller from aggressively harvesting cash or accelerating receivables collections just before the transaction completes. Negotiating the peg is not a neutral accounting task but a zero-sum commercial negotiation. Sellers advocate for a lower peg to maximise the likelihood of an upward adjustment, while buyers seek a higher peg to ensure the business is well-capitalised from day one.

Normalisation and the Trap of Seasonality

A common mistake in establishing the peg is the reliance on a single snapshot of the balance sheet. Most practitioners utilise a twelve-month rolling average to account for seasonal cycles, such as the typical year-end surge in software license renewals or project-based hardware deployments. However, for rapidly scaling technology companies, a twelve-month average may be inappropriately low, as it includes the smaller scale of the business from a year prior. In such instances, a 'normalised' peg might require adjustments for recent headcount growth or shifts in payment terms with major vendors. The objective is to identify a figure that represents the 'steady state' of the business at the precise moment of the handover, rather than an historical curiosity that no longer reflects the current expense base.

The Definition of Current Assets and Liabilities

Disputes post-closing almost invariably stem from the qualitative definitions within the Sale and Purchase Agreement. A standard definition of working capital identifies current assets minus current liabilities, but this simplicity is deceptive. The controversy often lies in what is excluded. For example, the treatment of trapped cash, aged receivables, or prepayments requires precise wording. If a buyer discovers after close that a significant portion of the accounts receivable is uncollectable, they will argue it should have been excluded from the working capital calculation. Conversely, the seller will argue that the historical accounting policies of the company, even if arguably aggressive, should be the sole governing factor if they were disclosed during the due diligence process.

The Accounting Hierarchy and Precedence

To mitigate the risk of litigation, sophisticated practitioners establish an accounting hierarchy within the transaction documents. This hierarchy dictates which standards take precedence in the event of a conflict. Typically, the first level of precedence is a set of specific accounting treatments agreed upon by both parties for the transaction. The second level is the historical accounting policies of the target company, and the third level is general GAAP or IFRS principles. Without this hierarchy, a buyer might attempt to use the completion accounts process to 'clean up' the balance sheet by applying more conservative standards than the target ever used historically. The seller must ensure that the completion accounts are prepared on a basis consistent with the target peg to avoid an unfair downward adjustment based purely on a change in methodology.

Debt-Like Items and the Boundary of Working Capital

The final area of complexity involves the classification of items that sit on the boundary between working capital and debt. In technology deals, items such as accrued bonuses, sales commissions, and long-term deferred revenue are frequently the subject of intense debate. If an item is classified as 'debt-like', it results in a dollar-for-dollar reduction in the purchase price. If it is classified as 'working capital', its impact is diluted by the peg mechanism. Buyers often push for customer deposits and aged payables to be treated as debt-like to ensure they are fully compensated for these liabilities. The CFO must remain vigilant to ensure that the same item is not counted twice—once as a reduction in working capital and again as a debt-like deduction—which would unfairly penalise the seller.