Enough to run the company through its operating cycle and its worst month without scrambling for new money. Start from how long cash is tied up in receivables and inventory, net of what suppliers finance; the peg should deliver that. Then add what a new owner needs on top: opening cash, because the seller usually keeps it, payroll that falls due before collections, supplier credit that may tighten under new ownership, and the seasonal low. Most lower-middle-market deals fund the swing with a revolver in place at closing and the permanent part with equity or the term loan.
- Sized from
- The operating cycle, the first payrolls and the seasonal low
- Usual funding
- A revolver in place at closing, plus cash put on the balance sheet
- ABL advance on eligible receivables
- Typically 80% to 90%
- Receivables typically ineligible
- More than 90 days past invoice
- Common mistake
- Cutting working capital to make the financing request smaller
Why a new owner starts short of cash
Most lower-middle-market companies are sold cash-free, debt-free: the seller keeps the cash in the bank and pays off the company's debt, and the buyer receives the company with a normal level of receivables, inventory and payables. That normal level is set by the working capital peg. The peg makes sure the buyer is not handed a company with its receivables collected and its payables stretched. It does not give the buyer any cash.
So on the first morning after closing, the company has receivables that will turn into cash over the coming weeks, inventory that will turn into receivables, and bills and payroll that are due now. Several things make the first months harder than the seller's steady state:
- Payroll comes before collections. The first payroll may fall due within days of closing, while the receivables the buyer acquired take their usual time to come in.
- Suppliers may tighten terms. A supplier who gave the seller generous terms for years may shorten them, or ask for deposits, until the new owner has a payment history. Every day of supplier credit that disappears is cash the buyer has to find.
- One-off costs. Insurance premiums paid up front, systems the seller's group used to provide, rebranding, and the cost of the seller's transition services.
- The seasonal low. A company that is comfortable on its annual average can be badly short in its slowest month, and a closing date just before the slow season lands the buyer in it at once.
Sizing it from the operating cycle
Working capital need is not a percentage of revenue that can be looked up. It comes from how the company collects, stocks and pays, and it is sized in two layers: the operating working capital the peg should deliver, and the cash the new owner needs on top of it.
Take a distributor with annual revenue of 36,500, or about 100 a day, and cost of goods of 25,550, or about 70 a day. Customers pay in 45 days, so receivables of about 4,500 are always outstanding. The company holds 30 days of inventory, about 2,100 at cost, and pays suppliers in 30 days, so suppliers finance about 2,100. Operating working capital is about 4,500. If the peg is set at that level, the buyer receives it in the company at closing.
| Layer | How to size it | In the example |
|---|---|---|
| Operating working capital | Receivables plus inventory, less payables, at normal levels; delivered by the peg | About 4,500, in the company at closing |
| Opening operating cash | The cash the company needs in the bank to meet payroll and bills as they fall due, tested against a monthly model | 1,000 |
| Tighter supplier credit | Payables that turn into earlier cash payments if suppliers shorten terms for a new owner | Up to 2,100 if every supplier did; say 700 if a third do |
| Seasonal low | The deepest cash shortfall in a monthly model of the first year, starting from the closing month | 1,200 |
| One-off transition costs | Insurance, systems, transition services | 300 |
| Liquidity needed on top of the peg | Sum of the layers above the peg | About 3,200 |
The figures in the right-hand column come from the company's own records: the days sales outstanding in its receivables aging, inventory turns, payables timing, the payroll calendar and the monthly revenue pattern over two or three years. Lenders will test each one, so each should be traceable to a document in the file.
Build a monthly cash model of the first year starting from the closing date. The month where it goes lowest is the liquidity you need.
Three ways to fund it
Once the amount is known, it can be funded with a revolving line in place at closing, with part of the term loan, or with equity put onto the balance sheet. Most well-structured deals use a revolver for the swing and equity or a modest term-loan amount for the permanent cushion.
| Revolver at close | In the term loan | Equity to the balance sheet | |
|---|---|---|---|
| How it works | A line sized to receivables and inventory, or to EBITDA, drawn as needed | Part of the acquisition term loan is paid into the company as cash | The buyer or sponsor contributes cash beyond the purchase price |
| Effect on debt service | Interest only on what is drawn, plus an unused line fee | Fixed principal and interest from the first quarter | None |
| Flexibility | Draws and repays with the cycle | Borrowed once; repaid on schedule whether needed or not | Fully flexible |
| Effect on leverage | Counts when drawn | Counts from day one, using up senior capacity | None |
| Best for | Seasonal and cyclical swings | A permanent cushion, where the lender allows it | Opening cash and one-off costs |
A revolver suits the part of the need that comes and goes. An asset-based revolver advances against the borrowing base: asset-based lenders typically advance 80% to 90% of eligible receivables, and inventory typically advances at up to 85% of net orderly liquidation value, or roughly half of cost. Receivables more than 90 days past invoice are typically ineligible, and borrowing bases commonly cap any single customer at 20% to 25% of eligible receivables. A company with concentrated or slow receivables will find its availability well below its receivables balance; how a borrowing base works sets out the arithmetic. A cash-flow revolver from the term lender is sized on EBITDA instead. How either sits beside acquisition debt is covered in using a revolver in an acquisition.
The term loan can carry some permanent cash, but it uses up senior leverage capacity that is usually needed for the price, and lenders rarely like term debt that sits in the bank. Equity is the cheapest in cash terms and carries no payments, so it is the natural source for opening cash and one-off costs. Cash a buyer keeps outside the company is not working capital unless it is actually available to the company, and lenders will ask.
Why under-funding is so common, and what it costs
Buyers cut working capital for understandable reasons. A smaller financing needs less equity. It has smaller payments, so coverage looks better. And the seller's company has always run fine, so it seems the cushion is not needed. Each of those reasons misses the same point: the seller's company ran on the seller's cash balance and the seller's supplier terms, and the buyer has neither.
The pattern after closing is familiar. By the second or third month, a slow-paying customer, a supplier who shortened terms and a payroll land in the same week. The revolver is drawn further than planned, availability shrinks, and a covenant tied to liquidity or fixed charge coverage comes closer. Most credit agreements limit additional borrowing, so the options narrow to stretching suppliers, asking the lender for an amendment, or asking the owners for more equity. None is a good position in the first year of ownership.
The funding choice also changes coverage. Suppose cash available for debt service is 1,400 against 1,000 of annual payments. Funding 500 of working capital through a term loan amortizing over five years adds 100 of principal a year plus interest, taking payments to roughly 1,150 and coverage below the 1.25x that conventional banks commonly look for. Drawing the same 500 on a revolver adds only the interest on what is drawn, and coverage holds. How lenders run the test is on debt service coverage ratio.
The peg, the closing date and seasonality
Two decisions made before the financing is arranged change how much working capital the buyer has to bring. The first is the peg. If it is set below the company's normal level, perhaps by averaging months when receivables were unusually low, the buyer inherits a company that will absorb cash to get back to normal. Every unit the peg is set too low is a unit the buyer has to fund. What a working capital peg is covers how it is set and trued up.
The second is the closing date. A contractor bought in late winter has to fund crews, fuel and materials for the season before the first spring invoices are paid. The same company bought at the end of its busy season comes with high receivables that will convert to cash. Neither is wrong, but the working capital plan should match the closing date, not the annual average. Seasonal companies are treated on seasonal lines of credit, and sizing a revolver on sizing a working capital line.
How to present the request to lenders
Lenders question working capital requests from both directions. An unsupported round number invites a cut. A plan with no liquidity at all invites the question of how the buyer will make the first payroll. What gets a working capital plan approved is showing the derivation.
- A line for cash to the balance sheet in the sources and uses table, separate from transaction costs.
- The AR aging by customer with days outstanding, the AP aging and the inventory report, which support the operating cycle and the borrowing base.
- A monthly cash model for the first year, starting from the closing date, with the low point and the revolver availability marked.
- The peg as agreed in the letter of intent, and how it compares with the normal level.
- What is funded by the revolver, what by the term loan and what by equity.
Midas Partners builds the monthly cash model into the financing model for every acquisition, so the working capital plan is derived from the company's own cycle and lenders see the low month rather than being asked to trust a figure. Once the documents are in, the full lender package is built in a day and checked by a senior banker; its contents are on the package. Of the 1,800+ lenders in Midas Partners's book, 235 write asset-based loans and lines.
Common questions
- If the working capital peg is set correctly, do I still need extra working capital?
- Usually. The peg delivers receivables, inventory and payables at normal levels, but in a cash-free deal the seller keeps the cash. The buyer still needs opening cash, a cushion for tighter supplier terms and the seasonal low.
- Should working capital go in the term loan or a revolver?
- Swings that rise and fall with the season or the order book fit a revolver. A permanent cash cushion is usually better funded with equity, because term debt uses up senior leverage capacity and adds fixed payments.
- Can I add a line of credit after closing instead?
- Sometimes, but the acquisition credit agreement will govern what else can be borrowed and on what lien. Arranging the revolver at closing, while the full file is in front of lenders and the intercreditor terms are being set, is usually easier.
- How is an asset-based revolver sized?
- From the borrowing base: a share of eligible receivables and inventory, less reserves. Receivables more than 90 days past invoice and concentrations above the lender's cap are typically excluded, so availability is usually well below the receivables balance.
- Will adding working capital hurt my coverage?
- Term debt adds payments, so coverage falls. A revolver draw adds only interest on what is drawn. The effect can be tested in the model before the request is made.