Working capital is part of what you are buying, and the clause decides whether you get it
Working capital is the money already at work inside the business: customer invoices not yet collected, inventory on the shelves, deposits and prepaid costs, minus the supplier bills, wages and accruals the business owes in the ordinary course. A business cannot run without it, because tomorrow's payroll and next week's supplier run are paid out of it while new sales are still becoming cash. When you buy a company, you are buying that working engine, not just the equipment and the name, and the price was set on the assumption the engine arrives full enough to run.
The clause exists because that assumption is dangerously easy to defeat. In the months before closing, a seller controls the levers: collect receivables hard, let inventory run down, stretch supplier payments, and the working capital quietly drains into the seller's pocket while the headline price stays untouched. Without an adjustment mechanism, you would pay the agreed price and then immediately inject cash of your own to refill what was drained. The working capital clause is the defence: it fixes a target, measures what is actually delivered, and moves the price dollar for dollar to close the gap, in either direction. It protects sellers too, since a business delivered with unusually fat working capital earns them a price increase.
One piece of context makes the rest legible: private deals are typically priced cash-free and debt-free, meaning the seller keeps the cash and pays off the debt, and what transfers is the operating business plus its normal working capital. The three conventions travel together, and the boundaries between them, what counts as cash, what counts as debt, what counts as working capital, are where the negotiation actually happens.
The peg is the target the deal gets measured against, and setting it is the real negotiation
The peg, sometimes called the target, is the dollar amount of working capital the parties agree is normal for this business, and everything else in the mechanism just measures distance from it. The standard method is an average of month-end working capital over a trailing period, commonly twelve months, calculated under the same definitions the agreement will use at closing. Twelve months matters because it washes out seasonality: peg a landscaping business off its spring balance sheet or a retailer off December and the number is systematically wrong, in one side's favour, every time.
Setting the peg well is diligence work, not arithmetic. The historical balances have to be tested before they are averaged: receivables aged, with stale accounts removed rather than averaged in as if they were collectible; inventory checked for stock that has not moved in a year but still carries full value; payables reviewed for whether the seller was already stretching suppliers, which understates normal liabilities and flatters the target. This is one of the quiet payoffs of proper financial due diligence before buying a business: the same file that tests the earnings also tells you what normal working capital genuinely looks like, so the peg is grounded in evidence instead of the seller's average of untested numbers.
Growth adds one more wrinkle worth naming. A business growing quickly needs more working capital every quarter, so a trailing average understates what the business will need under you; a shrinking business flips the logic. Sophisticated agreements sometimes set the peg off the recent run-rate rather than the full year, and a buyer's own financial projections should model the working capital the plan actually requires, which is frequently more than the peg delivers.
What counts as working capital is negotiated line by line
The definition matters more than the peg, because every included or excluded item moves the adjustment dollar for dollar. The broad shape is standard, current assets minus current liabilities, with cash and interest-bearing debt carved out by the cash-free debt-free convention. The arguments live in the specific lines.
| Item | Where it usually lands | Why it gets argued |
|---|---|---|
| Accounts receivable | Included, often net of an aging cut-off | Whether old or disputed balances count at face value |
| Inventory | Included at the lower of cost and value | Slow-moving and obsolete stock inflating the delivered number |
| Customer deposits and deferred revenue | Contested: liability in working capital, or a debt-like item | It is cash the seller already collected for work you must deliver |
| Related-party balances | Usually excluded and settled at closing | They exist for the seller's tax planning, not operations |
| Accrued vacation and bonuses | Included as liabilities when the definition is honest | Sellers prefer to leave unrecorded accruals out of the count |
| HST and tax balances | Netted or excluded, deal by deal | Whether they behave like operating items or like debt |
Deferred revenue deserves its own sentence, because it is the single most expensive line buyers concede. Deposits, gift cards, prepaid contracts and retainers are cash the seller has already banked for work, product or service you will have to deliver after closing at your cost. Treated as an ordinary working capital liability it simply lowers the delivered number; treated as a debt-like item it reduces the price directly, which is usually the honest economics. Which treatment applies is negotiated, and silence defaults to whichever side drafted the definition.
Notice also what the definition interacts with: the transaction structure. In a share purchase the working capital arrives inside the corporation automatically and the clause simply prices it. In an asset purchase you and the seller choose deal by deal whether receivables, inventory and payables transfer at all, so the working capital mechanism has to be built to match what is actually being bought; the structural choice itself is covered in asset purchase versus share purchase.
The true-up happens after closing, and it is a small negotiation of its own
The adjustment runs in two passes because nobody knows the real number on closing day. At closing, the price is settled using an estimated working capital statement, prepared by the seller shortly before the date. Then, typically sixty to ninety days later, a closing statement is prepared from the actual books as they stood at the closing moment, usually by the buyer this time, and the difference between actual and peg moves money: below the peg, the seller refunds the shortfall; above it, the buyer tops up. Dollar for dollar, with no materiality cushion unless the agreement added one.
Because each side prepares one of the two statements, the mechanism anticipates disagreement and builds in a resolution path: the receiving side has a window to object, the parties negotiate, and unresolved items go to an independent accountant whose determination binds both sides, usually item by item rather than splitting the difference. Two practical protections matter more than any drafting flourish. First, consistency language, requiring the closing statement to be prepared using the same accounting policies and practices as the peg, because a policy change between the two dates is how sophisticated parties move six figures without touching a single balance. Second, a holdback or escrow sized to a plausible adjustment, so that if the true-up runs your way, you are collecting from an account rather than chasing a seller who has already been paid in full.
Working capital is also your day-one financing question
Even a perfectly drafted clause only ensures you receive a normal engine; it does not fund the first months of running it, and buyers regularly confuse the two. From day one, payroll and suppliers are paid on schedule while the receivables you acquired take their usual weeks to collect, and any growth you are planning consumes cash before it returns it. That gap is a financing requirement in its own right, which is why acquisition lenders expect the package to include an operating line sized to the working capital cycle alongside the term loan that funds the price, and why they read the cash flow forecast for the first year as carefully as the debt service coverage on the loan itself.
Lenders will also keep measuring after funding: operating lines are commonly margined against receivables and inventory with monthly reporting, so the quality of the working capital you negotiated for keeps mattering long after the true-up settles. Building this file, the peg analysis, the first-year cash flow forecast, the operating line request and the projections behind both, is business financing and projections work by a CPA firm for Ontario buyers, and it sits under our Business Financing Advisory practice as a normal part of acquisition support.
Five facts change the number, and the clause rewards preparation
What working capital means for your deal comes down to five facts worth naming before the agreement is drafted. The seasonality of the business, which decides whether a twelve-month average or a different peg method is honest. The presence of deposits and deferred revenue, and whether they are treated as working capital or as debt-like reductions to price. The quality of the receivables and inventory inside the historical numbers the peg is averaged from. The trajectory of the business, since growth needs more working capital than any backward-looking peg delivers. And the transaction structure, which sets whether working capital transfers automatically or by negotiation. A buyer who has those five answered holds the pen on the definitions; a buyer who has not is accepting someone else's arithmetic.
We handle the working capital mechanics as part of acquisition engagements under Strategic Projects: testing the peg during diligence, negotiating the definitions alongside your lawyer, preparing or reviewing the closing statement, and carrying the dispute if one comes. The wider context, price, structure, tax and financing together, is mapped in buying a business in Canada, and a free 15-minute discovery call is enough to tell you whether the clause in front of you protects you or merely mentions working capital.
