I don't really get it. What's the point of agreeing on an amount if the purchase price is just going to adjust later to account for differences between the peg amount and the actual? Thanks.
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Good question. NWC is something I think a lot of junior bankers don't think about but can be an important part of the final negotiations...
The point of the peg is to make sure the company is delivered with ample working capital to function "normally" post close. In other works, the sellers don't drain the business right before the sale. For example, if the company was operating as normal, then in the last month leading up to the sale, the sellers collected as much as possible from customers (decreased AR), sold off all inventory (decreased inventory) and stopped paying suppliers (increased AP) NWC would drop significantly. If there was no peg in place, the sellers would receive this extra cash and the buyer would then be left with a business that immediately needs extra cash invested (to buy inventory, to pay suppliers, etc.) to be able to operate "normally" again. This is obviously an extreme example, but the peg helps avoid this type of situation from occurring.
So what does the peg itself do exactly? Is it an agreement that the company has to maintain a certain level of working capital. What if they breach it?
The peg is part of the negotiation of the sale. The peg is set and at closing the actual working capital position is compared to the peg, and depending on if it's above or below the peg the buyer or seller would pay that amount.
The buyer or seller pays the delta between final working capital delivered and the agreed-upon working capital peg.
If the working capital delivered is below the agreed upon peg, the seller pays; if it's above, the buyer pays
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