Avoiding “Working Capital Pegs” on SMB Deals

In the lower middle market for small and medium-sized business (SMB) transactions below $5M (EBITDA < $1M), simplicity is key to ensuring a smooth M&A deal process. Complex financial mechanisms like working capital pegs are not only unnecessary but lead to confusion, disagreements, and unnecessary delays, particularly in sectors like IT or Digital Marketing. A “working capital peg” is often used in larger deals to ensure the business maintains a normalized level of working capital following the close. 

However, in smaller transactions, this concept tends to complicate the deal unnecessarily. Buyers and sellers should focus on a clear, straightforward approach: the seller keeps all accounts receivable (AR) and pays all accounts payable (AP), ensuring a smooth business acquisition process. Revenue received for work that hasn’t yet started should be left behind for the buyer at closing. 

Five Reasons to Eliminate Working Capital Requirements in SMB Acquisitions

1. Reduces Complexity and Disputes: The nature of IT and Digital Marketing businesses—often service-driven and cash-flow-centric—means there’s little need to introduce complex calculations for normalized working capital. Simplifying the agreement prevents misunderstandings and minimizes the likelihood of disputes during closing.

2. Aligns Value with Cash Flow: With IT and Digital Marketing firms, the primary value lies in the team, the customer relationships, and the recurring revenue, not inventory or receivables. Allowing sellers to keep AR and handle AP ensures the deal structure focuses on the actual cash flow and profitability of the business.

3. Faster Deal Process: SMBs often lack the robust financial reporting and resources of larger firms. Negotiating and auditing a working capital peg takes time and effort, slowing down the transaction. A simplified structure expedites closing and allows both parties to move forward with confidence.

4. Better Financing Flexibility: Buyers can calculate what is needed at close, adjust their valuation, and incorporate those funds into their business acquisition financing upfront. This avoids surprises and ensures adequate liquidity without tying up resources in prolonged post-closing adjustments.

5. Focus on What Matters: Small business owners and sellers value clarity, simplicity, and predictability. By removing the PEG and sticking to a straightforward structure, buyers demonstrate professionalism and focus on the elements that truly drive value, such as team performance and client retention. In SMB acquisitions, particularly in IT and Digital Marketing, simplicity and transparency are crucial. 

Avoiding working capital pegs is a smart way to streamline negotiations and foster trust between buyers and sellers. Focus on what matters most and leave unnecessary complexities behind.