Buyers and sellers negotiate the headline price hard and the working capital mechanism casually. This is the wrong way round. The mechanism routinely moves more money than the last round of price negotiation did, and it moves it after you have stopped paying attention.
What the peg is for
You agree a price on a cash-free, debt-free basis. That price assumes the business comes with a normal amount of working capital: enough stock, debtors and creditors to keep trading without an immediate cash injection.
Without a mechanism, a seller could collect every debtor, stretch every creditor and run inventory to nothing before completion, extracting cash while handing over a business that needs funding on day one. The peg prevents that.
If actual working capital at completion exceeds the target, the buyer pays the excess. If it falls short, the price is reduced.
How the peg gets set, and where it goes wrong
The usual approach is an average of monthly working capital over the preceding twelve months. Simple, and full of traps.
Seasonality. A business whose working capital peaks in November and troughs in February has an average that describes neither. If completion is in February, a twelve-month average target means the seller pays for a shortfall that is entirely normal for that month. Seasonal businesses need a seasonally adjusted peg or a completion date chosen with the profile in mind.
Growth. A growing business needs more working capital each month. A trailing twelve-month average is therefore below the current requirement, which favours the seller. Buyers who understand this argue for a shorter reference period or a growth adjustment. Sellers should expect it.
Definition. What is in and what is out matters as much as the number. Is accrued but unbilled revenue included? Deferred income? The current portion of finance leases? Corporation tax? Intercompany balances? Each is arguable, and each moves the outcome. Agree a line-by-line definition, with a worked example on a historical balance sheet, before signing.
Consistency. The peg must be calculated on the same basis as the completion balance sheet. Differences in accounting policy between the two produce a mismatch that has nothing to do with performance.
Where sellers actually lose money
Agreeing the peg before understanding the profile. The peg is often set early in a process, from headline figures, and only examined properly during diligence. By then it is anchored.
No dispute mechanism, or a bad one. Completion accounts prepared by the buyer, disputed by the seller, resolved by an independent expert. If the process is not specified tightly, including who prepares, what timescales apply and how the expert is appointed and instructed, disputes drag and cost more than the amount at issue.
Bad debt provisions applied at completion. A buyer preparing the completion accounts may take a more conservative view of receivable recoverability than the seller did. Specify the provisioning policy in the definition.
Cut-off. A few days either way on revenue and cost recognition moves working capital materially. Cut-off procedures at completion should be agreed, not assumed.
Double counting between working capital and net debt. An item classified as debt-like in the net debt calculation and also deducted within working capital is charged twice. This happens more often than it should, particularly with accrued interest, unpaid tax and deferred consideration.
Locked box as the alternative
A locked box fixes the price by reference to a historical balance sheet date. From that date the seller is prohibited from extracting value except by permitted leakage, and the buyer usually pays interest on the equity value from the box date to completion.
The trade-off is straightforward. A locked box gives price certainty and avoids a post-completion argument, which sellers generally prefer. Completion accounts give accuracy, which buyers generally prefer. A locked box requires the buyer to be comfortable with the historical balance sheet, so it works best where the accounts are audited and the diligence is thorough.
In practice locked boxes have become more common in mid-market deals, largely because both sides value certainty over precision once the sums involved are understood.
What to do before signing
Model the mechanism. Take the definition as drafted, apply it to the last twelve monthly balance sheets, and see what the outcome would have been at each date. It takes a day and it is the only way to see what you have actually agreed.
Then negotiate the definition rather than the number. The number attracts all the attention. The definition decides the result.