Meaning
Reference points used in a purchase agreement define the normal level of current assets and liabilities required to operate a business. This working capital peg acts as the baseline for the post-closing adjustment, ensuring that the buyer receives a company with enough liquidity to function. It is typically calculated as a historical average of the net working capital over the twelve months preceding the sale.
Economic Neutrality
Setting the correct level prevents either party from gaining an unfair advantage through seasonal fluctuations or unusual accounting practices. If the actual working capital at the time of closing is above the working capital peg, the purchase price increases to reimburse the seller for the excess value. Conversely, if the level is below the target, the price is reduced to compensate the buyer for the shortfall.
Normalization Process
Accountants analyze the balance sheet to remove non-operating items and ensure that the figures represent the true requirements of the business. The working capital peg must account for growth trends and capital expenditure cycles to be an accurate measure of operational health. Disagreements often arise over the inclusion of slow-moving inventory or disputed receivables in the final calculation.
Closing Verification
Detailed schedules in the share purchase agreement outline the specific accounts that will be used to calculate the final number. Once the transaction closes, a formal audit confirms how much the actual figures deviated from the working capital peg. This process ensures that the transition of ownership does not result in a sudden cash drain on the newly acquired enterprise.
Both parties agree on the accounting standards to be used during the audit to prevent inconsistent results.
