Working Capital Pegs, Earn-Outs, and Escrow: The Post-LOI Fine Print

The gap between a headline purchase price and a seller's actual net proceeds is closed by three mechanisms that operate in the background of every middle-market transaction: the working-capital peg, the earn-out, and the escrow. Understanding each — and negotiating them correctly — is the difference between a good LOI and a good outcome.

Middle-market transactions are typically structured on a cash-free, debt-free basis with a normalized level of working capital delivered at close. That normalized level — the peg — is usually calculated as a trailing twelve-month average of net working capital, defined to include or exclude specific line items.

If the actual working capital at close is above the peg, the seller receives the excess. If below, the buyer withholds the shortfall. The dollars involved can be surprisingly large — a $2 million peg miss is common, and rarely favorable to the party that did not model it.

The single mistake sellers make is treating the peg as a formula the accountants will handle later. It is not. The definition of working capital (does it include deferred revenue? tax accruals? accrued bonuses?) and the calculation window are both negotiated, both legitimately negotiable, and both worth real money.

Earn-outs bridge valuation disagreements. When a buyer will not underwrite the seller's projections, an earn-out shifts the difference to the future — payable if the business hits agreed targets over one to three years post-close.

The academic literature is consistent: on average, sellers collect between forty and sixty percent of headline earn-out consideration. The dispersion is wide. Earn-outs tied to revenue collect more often than earn-outs tied to EBITDA. Earn-outs with clear, simple metrics collect more often than earn-outs with adjusted, negotiable metrics. Earn-outs with buyer covenants — obligations to operate the business consistently with historical practice — collect more often than earn-outs without them.

The practical guidance is unromantic. Treat earn-out consideration as a probability-weighted number, not a headline. Negotiate the metric definitions in writing. Insist on operating covenants. And if the earn-out is more than roughly 20% of total consideration, ask whether the transaction is worth doing at the price the buyer is actually offering with confidence.

Escrow — typically 5% to 10% of enterprise value held for twelve to eighteen months — secures the buyer's indemnification claims for breaches of representations and warranties. For most middle-market deals in 2026, representation and warranty insurance (RWI) has substantially reduced escrow requirements, replacing much of the traditional escrow with an insurance policy.

RWI is not free, but it is usually cheaper than the alternative — a full escrow tied up for eighteen months. For deals above roughly $30 million in enterprise value, RWI is close to standard, and any advisor not raising it as an option is not serving the seller.