redactedWorking capital is simply cash tied up in the daily engine of a business, without it the engine stops running. In a standard accounting textbook, Net Working Capital (NWC) is defined as Current Assets minus Current Liabilities. I think that is where the confusion stems from between business buyers and sellers. To a business owner (seller) NWC is simply cash tied up. A more dynamic equation that both business buyers and sellers will understand is this: Net Working Capital = Inventory + Accounts Receivable - Accounts Payable When buying a business in a standard "cash-free, debt-free" asset deal, you pay the agreed purchase price and expect the seller to deliver the business with a full tank of operational fuel. That expected fuel level is what we call the Working Capital Peg. If the business holds more capital at closing than the agreed peg, the buyer pays for that excess value. Conversely, if there is less, the seller covers that shortfall - typically through a dollar-for-dollar discount on the final purchase price at closing. The problem arises when both parties cannot agree on what that working capital peg should be. In my experience, many first-time sellers, especially those without an advisory team find it incredibly difficult to wrap their heads around why they have to leave their hard-earned receivables behind. On the buy side, buyers tend to use the working capital peg as a mechanism for de-risking the business, which naturally tilts their bias to push this target number as high as possible. My hope is that this article proffers solutions to drastically reduce or prevent those working capital disputes. Let’s set the stage using a concrete example of an electrical utility contractor that replaces power poles for regional energy cooperatives. Imagine for just this section that Tuesday, and Friday are not single days, but rather representative of entire months or quarters in a business cycle. Tuesday The contractor wins an emergency task order to replace storm-damaged lines. Then purchases $50,000 of specialized utility poles and transformers from a supplier on 30-day credit terms. If you buy this business on a Tuesday night, the net working capital (NWC) formula reads $0. The seller might try to argue “we agreed to use the formula and it reads zero, you are getting a business with $50k in inventory, $0 accounts receivables, and $50k in payables. Go run the job, all the best”. If a buyer accepts that argument, they will slam into a liquidity wall by Friday. Because by Friday, field payroll is due, and no operating cash inflow to cover it. Remember working capital is cash tied up. At this point, the business hasn't actually spent its own cash or realized its true burden, but the engine is starving for upcoming liquidity. Friday The work is completed successfully. The contractor pays $25,000 in weekly field payroll. They issue a formal invoice to the utility cooperative for $120,000 (covering materials, labor, and profit). The utility co-op has a strict Net-60 payment policy. · Accounts Receivable (Asset): +$120,000 (Money the utility co-op owes to contractor) · Inventory (Asset): $0 (The poles are in the ground) · Accounts Payable (Liability): $50,000 (Contractor is still owing the material supplier) · NWC is now $70,000 The $70,000 represents $25,000 of cash paid to workers on Friday, plus $45,000 of paper profit that is trapped in a 60-day billing cycle. If you bought the business on Tuesday at "$0 NWC," you would have to pull $25,000 out of your personal pocket, or some form of financing by Friday just to cover payroll. Inability to meet that payroll potentially causes you to lose out on a job of $45,000 profit, and unable to convert the inventory to receivables. The seller effectively starved the business engine of the cash required to execute the very assets left behind. NWC on Tuesday and Friday are very different. Because working capital in the energy sector expands and contracts so wildly, calculating it at a single point in time is highly dangerous. When thinking about solutions for working capital disputes in acquisitions, consider ways to provide clarity before the Letter of Intent (LOI) is signed. Traditional LOIs contain one-sentence language stating that the transaction includes a "normal level of working capital to be agreed upon later”. That is vague and is a recipe for future disputes. I recommend a more proactive approach, perhaps spelling out what current assets and current liabilities will be recognized in the calculation. Removing ambiguity around unbilled revenue since it impacts receivables and inventory. The LOI should explicitly state that Unbilled Revenue/WIP will only be included in the closing NWC calculation if it has met specific, verifiable project milestones (e.g., signed daily field tickets or passed safety inspector clearances) and is contractually billable within 15 days of closing. Other actions that can be done post LOI include: Establish "Month-Specific" Peg Targets For seasonal contractors whose work peaks during summer grid expansions or declines during winter freezes, a flat 12-month historical average peg is a structural mistake. Instead, outline a Month-Specific Peg Target based on a rolling 3-year historical average for that specific calendar month. Meaning that if you close in say May, compare the closing balance to the average of previous Mays (May 2023, May 2024, and MayredactedThis compares apples to apples and eliminates massive, unexpected closing adjustments. Explicitly Define "Actual NWC" and the "Lookback Period" Define Actual NWC as the balance of eligible current assets minus eligible current liabilities as determined from the closing statement prepared in accordance with the same accounting principles and methodologies used to set the Target NWC. Closing statement should be spelled it, that’s an “as of” date for example, last 30 days prior to closing date, or last full month prior to closing date. Also specify the definition of "Eligible A/R". Explicitly exclude or heavily discount any A/R aged over 90 days. Same with any invoices currently tied up in client performance disputes or structural holdbacks. Build the True-Up and Escrow Mechanics Directly into the LOI This is pre-LOI but execution is post LOI. Part of providing working capital peg clarity through the LOI should include spelling out the exact financial consequences of a target versus actual mismatch. Let me also elaborate on a timing point that makes the rest easy to understand. There are really two dates here – the measurement date and the determination date. Actual NWC is measured as of closing, but it isn’t known then since that period’s books have yet to close. So, the final figure isn’t determined until all of that settles, usually 90 to 120 days after close (determination date). This means the bulk of the cash consideration is wired at closing, but the true-up, in either direction, waits for the finalized closing balance sheet. Here are standard consequences that I find to be generally agreeable in simple deals: If Actual is Higher than the Peg, the excess amount is added to the purchase price and paid to the seller over a deferred period, ensuring the buyer doesn't drain their Day 1 cash. If Actual is Lower than the Peg, the shortfall is deducted dollar-for-dollar from the closing cash consideration or pulled directly from a dedicated Working Capital Escrow (ideally 1% to 2% of the total transaction value held back for 90 to 120 days). Conclusion In lower middle market energy M&A, working capital is a volatile operational reality. What I find interesting is that the standard SBA QoE requirements don’t address working capital at all, let alone the rigorous, industry-specific nuances that decide these energy deals. Here is what I want buyers and sellers to take away. The working capital peg is not the buyer trying to claw back value, and it is not the seller surrendering hard-earned receivables. It is both parties agreeing, in advance, on how much cash the company needs to keep running. Framed that way, it is no longer a fight and becomes a shared answer to a shared question.