TL;DR: The working capital peg determines how much operational cash the seller delivers at close. Most first-time search fund buyers define it too late, set it too loosely, or miss the deferred revenue trap. Fix this in the LOI, not the purchase agreement.
A buyer once extracted $20 million of value from a $1.4 billion acquisition by arguing that deferred revenue should be excluded from the working capital calculation. The seller had a finance executive in the room who had already signed off on the language. According to Searchfunder.com's analysis of the transaction, the deal terms were buried in the letter of intent and no one caught it until it was too late.
That is not a story about a sophisticated buyer. It is a story about an unsophisticated seller and an LOI that left the working capital definition vague. Search fund operators are typically on the buying side of smaller deals, but the lesson applies at every size: net working capital is where real money changes hands, quietly, after the headline purchase price is agreed.
What Net Working Capital Actually Means in ETA
Net working capital (NWC) is current assets minus current liabilities. In a search fund acquisition, that translates to the operational cushion the business needs to function on day one of your ownership.
The typical ETA deal is structured on a cash-free, debt-free basis. The seller retains all cash and pays off all interest-bearing debt at close. What remains on the balance sheet: receivables, inventory, prepaid expenses on the asset side; payables, accrued liabilities, and sometimes deferred revenue on the liability side. That is the working capital the buyer inherits.
The purchase price you negotiate assumes the business arrives with a normal level of working capital. The working capital peg is how you define what normal means.
How the Peg Gets Set
The peg is a target number. If the actual NWC at close matches the peg, no purchase price adjustment occurs. If actual NWC is below the peg, the seller owes the buyer the difference. If actual NWC is above the peg, the buyer pays the seller the excess.
Three common methods for setting the peg:
- Trailing 12-month average: Calculate average NWC over the past year. This is the most common approach for stable businesses because it smooths seasonal swings and one-time events.
- Last month-end: Use NWC as of the most recent month-end before signing. Simpler but vulnerable to manipulation if captured at an unusual point in the business cycle.
- Normalized method: Start with the historical average, then adjust for known changes: new payment terms, inventory efficiency initiatives, recent contract additions. More accurate but requires more negotiation.
According to SRS Acquiom's 2023 Deal Terms Study, which analyzed over 1,200 transactions, the median working capital collar width runs approximately 1 to 2 percent of enterprise value. Most quality-of-earnings analyses use the trailing 12-month average as the starting point, with normalized adjustments shifting the final figure 5 to 10 percent from the simple average.
For most small businesses acquired through search funds, the working capital peg falls between 5 and 15 percent of annual revenue, depending on industry. Service businesses with short receivable cycles run closer to 3 to 8 percent. Distribution and manufacturing businesses often require 15 to 25 percent, per SearchFundMarket's analysis of ETA transaction data.
The Three Negotiation Battlegrounds
The specific items included in or excluded from the working capital definition determine who wins on the peg. Sellers want to exclude current liabilities and include current assets. Buyers want the reverse. Here is where it gets specific.
Deferred Revenue
Deferred revenue is cash the seller already collected from customers for services not yet delivered. It sits on the balance sheet as a current liability. When you acquire the business, you inherit the obligation to deliver those services, but the seller already pocketed the cash.
If deferred revenue is excluded from the working capital calculation, the seller walks with both the cash and the obligation, and you are left delivering services you effectively paid for. The correct buyer position: include deferred revenue in the NWC calculation and set its peg at zero, forcing the seller to leave cash on the balance sheet equal to the deferred revenue balance. This matters most in recurring-revenue businesses, SaaS models, and any company that collects annual or multi-year contracts upfront.
Payroll and Bonus Accruals
These are wages and commissions earned by employees before close but not yet paid. They are a current liability the buyer inherits. If payroll accruals are excluded from working capital, the buyer writes those checks without any corresponding adjustment to the purchase price.
The correct position: include payroll and bonus accruals and set their peg at zero, forcing the seller to leave enough cash to cover pre-close compensation obligations. As accounting firm GGG notes in their ETA diligence analysis, failing to categorize these "debt-like" items correctly is one of the most common errors in search fund deal diligence.
Accounts Receivable and Accounts Payable
In a healthy business, receivables typically exceed payables in aggregate, but timing creates asymmetry. A seller under pressure may accelerate collections before close, calling in receivables early, or delay vendor payments to pump up the balance sheet. Both moves inflate working capital artificially.
The protection: use a 12-month trailing average rather than a point-in-time snapshot for the peg. A trailing average neutralizes most manipulation because it is harder to sustain abnormal collection or payment patterns for 12 months. Some purchase agreements add a "conduct of business" covenant requiring the seller to operate within 10 to 15 percent of historical working capital norms during the pre-close period.
The True-Up Process
At close, the parties agree on an estimated closing balance sheet. The initial purchase price is based on that estimate. Within 60 to 90 days after close, the buyer prepares a final closing balance sheet showing actual NWC as of the closing date. The seller has 30 to 45 days to review and object. If they disagree, parties negotiate. Unresolved disputes go to an independent accounting firm for binding determination.
According to KPMG's post-closing disputes analysis, approximately 10 to 15 percent of acquisitions result in formal working capital disputes, with the average disputed amount ranging from $200,000 to $500,000 in mid-market transactions. At search fund deal sizes, typically $2 million to $15 million in enterprise value, a dispute of $50,000 to $200,000 is not unusual and can materially affect first-year returns.
Many agreements hold 10 to 20 percent of the estimated working capital in escrow at close to ensure funds are available for buyer-favorable adjustments. If no escrow is used, you are relying on the seller's post-close creditworthiness to make you whole.
Define the dispute resolution process clearly in the purchase agreement. Who prepares the closing balance sheet? What accounting principles apply? Who selects the independent accountant and how are their fees allocated? Vague language here generates legal fees and delays.
Define It in the LOI
The single most common mistake first-time search fund buyers make on working capital: deferring the definition to purchase agreement negotiation. By the time your lawyers are drafting the definitive agreement, the seller's attorney is dug in and every line item becomes a separate fight.
Your letter of intent should specify four things:
- The specific methodology for calculating the NWC peg, whether trailing 12-month average, normalized, or another agreed approach
- Which balance sheet items are included and excluded, with deferred revenue and payroll accruals explicitly addressed
- The post-close true-up timeline and escrow mechanics
- The dispute resolution process if parties disagree on the closing balance sheet
Sellers who resist defining working capital in the LOI are often planning to negotiate it aggressively in the definitive agreement. That is a red flag worth paying attention to before you sign.
Seasonal Businesses and Timing Risk
If the business has seasonal working capital swings, a landscaping company with peak summer receivables or a tax preparation firm with Q1 concentration, the timing of your closing matters. A business closing at seasonal peak may deliver substantially more working capital than one closing at a trough, even though both reflect normal operations.
For seasonal businesses, use the longest historical average you can support, 24 to 36 months, and consider a normalized peg that adjusts for the expected seasonal position at the planned closing date. Your quality-of-earnings provider should model the seasonal NWC cycle explicitly as part of diligence.
This timing dimension also connects to earnout structures, where working capital and cash flow timing affect the baseline from which earnout performance is measured. Getting the NWC peg wrong can distort the starting position for any performance-based contingent consideration.
The Bottom Line for Search Fund Operators
Working capital negotiation is not a technical detail to delegate to lawyers. It is a direct transfer of value between buyer and seller, often worth 1 to 3 percent of total enterprise value. On a $5 million acquisition, that is $50,000 to $150,000, real money that affects your year-one liquidity and your return to investors.
The operators who get this right start early. They analyze the target's working capital cycle in diligence: how fast receivables come in, how slowly payables go out, whether deferred revenue is a liability the business is currently burning through or accumulating. They define the peg explicitly in the LOI. They build escrow provisions into the deal structure.
The ones who get it wrong show up at close having agreed to a headline price and a vague "normal working capital" standard. Their lawyers then spend two weeks arguing about what normal means. The buyer either accepts a worse deal or loses the transaction.
Define it early. Defend it in diligence. Close with the capital you negotiated.
Frequently Asked Questions
What is a working capital peg and why does it matter in a search fund deal?
The working capital peg is a target number that defines the normal level of operational cash the business should deliver at close. If actual net working capital at close is below the peg, the seller owes the buyer the difference. If it is above, the buyer pays the seller the excess. Defining it loosely is where real money changes hands quietly after the headline price is set.
Why is deferred revenue the most dangerous item in a working capital negotiation?
Deferred revenue is cash the seller already collected from customers for services not yet delivered. If it is excluded from the working capital calculation, the seller walks with both the cash and the obligation to deliver, leaving the buyer to perform services it effectively paid for. The correct buyer position is to include deferred revenue and set its peg at zero.
What should a search fund operator specify about working capital in the LOI?
The LOI should specify the methodology for calculating the peg, which balance sheet items are included or excluded with deferred revenue and payroll accruals addressed explicitly, the post-close true-up timeline and escrow mechanics, and the dispute resolution process. Deferring this definition to the purchase agreement negotiation is the single most common mistake first-time buyers make.
How should a buyer handle working capital in a business with seasonal revenue swings?
For seasonal businesses, use the longest historical average you can support, 24 to 36 months, and consider a normalized peg that adjusts for the expected seasonal position at the planned closing date. A quality-of-earnings provider should model the seasonal net working capital cycle explicitly as part of diligence.
