Working Capital Adjustments in Manufacturing M&A Deals
Reviewed by Scott Nielson, CPA, Partner, Director of Tax on
Two Idaho manufacturers sign LOIs at the same $12 million enterprise value in the same month. Ninety days after closing, one seller receives an additional $400,000 in the working capital true-up. The other seller writes a check to the buyer for $600,000. The difference is not fraud or bad faith. It is the mechanics of the working capital peg and what happens when the seller does not understand how the buyer will calculate the delivered balance at close.
Working capital adjustments are the most commonly misunderstood mechanic in a manufacturing M&A deal. For a family owner used to running the balance sheet the way it has always been run, the calculation feels arbitrary. The buyer’s math is not arbitrary at all.
What a Working Capital Peg Actually Is
Enterprise value in an M&A deal typically assumes a “normalized” level of working capital delivered at close. That normalized level is called the peg. If the seller delivers more working capital than the peg (higher net current assets), the seller gets a payment upward. If the seller delivers less, the buyer gets a reduction to purchase price.
Working capital for peg purposes is generally defined as current assets excluding cash minus current liabilities excluding debt. The exclusions matter: cash is treated separately, and debt is treated separately, because both are already accounted for in the enterprise value to equity value bridge.
How Buyers and Sellers Calculate the Peg Differently
The peg is negotiated in the LOI or purchase agreement, but the underlying calculation almost always comes from a trailing 12-month average of the target’s working capital. That sounds neutral. It is not.
Buyers typically want the peg calculated on GAAP-adjusted working capital, which strips out any inventory overstatements, AR aging that has not been reserved, or other classification issues that inflate reported working capital. Sellers typically want the peg calculated on the reported balance sheet, unadjusted. The difference can be seven figures on a mid-market manufacturer.
Where the peg is set determines whether a seller who has been running normal operations delivers a “surplus” or a “shortfall” at close.
The Inventory Scrub: Where Value Disappears
Inventory is the single largest source of working capital adjustments in a manufacturing deal. A buyer’s diligence team will look for:
- Aged inventory beyond a defined threshold (typically 12 to 18 months)
- Raw material or work-in-progress with no clear finished-product path
- Finished goods without recent order activity
- Inventory carried at standard cost when actual cost is lower
- Consigned or customer-owned inventory that should not be on the books
Any of these gets reserved down for the peg calculation. A $2 million reported inventory that reserves to $1.4 million after diligence takes $600,000 of working capital out of the seller’s deliverable.
AR Aging and Bad Debt Reserves at Close
Similar mechanics apply to accounts receivable. Buyer diligence will apply a reserve to any AR aged beyond a defined threshold (typically 90 days), any receivable from a customer with a payment history problem, and any receivable that lacks documentation of the underlying order.
Sellers who have been aggressive about reporting gross AR without reserving realistically for uncollectibles will see the peg calculation strip down the delivered AR at close.
The 90-Day Post-Close True-Up
The typical purchase agreement provides for a working capital true-up 60 to 90 days after close. The buyer prepares a final calculation of working capital delivered at close, compares it to the peg, and the difference is paid one way or the other.
Disputes on the true-up are resolved either through a defined dispute mechanism (an independent accountant chosen in advance) or through litigation. Well-drafted purchase agreements name the accountant and cap the dispute time, which usually holds down the litigation risk.
Negotiation Levers Before the LOI
Sellers who understand the working capital mechanic negotiate three things before signing the LOI:
- The peg definition: GAAP-adjusted or reported? Which specific accounts count?
- The calculation window: trailing 12 months, trailing 6 months, or the average of the last two year-end balance sheets? Recent quarterly performance can move the answer meaningfully.
- The inventory and AR reserve methodology: which aging categories get reserved, at what percentage, and by whom?
Every one of these is negotiable pre-LOI. After the LOI is signed, the peg is essentially locked in, and only the amount delivered at close is up for interpretation.
The best time to prepare for the working capital adjustment is 12 to 18 months before going to market. Cleaning up inventory reserves, aging AR, and getting the balance sheet to look like the buyer will want to see it takes time. The manufacturing team at Cooper Norman has walked Idaho and Utah manufacturers through the diligence and true-up process, and our business transition planning group starts working with owners well ahead of a planned sale to protect the peg before the negotiation ever starts.
This overview is general information, not legal or accounting advice for your specific transaction. Talk with a Cooper Norman advisor about how these mechanics apply to your deal.