Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / Why Seller Net Working Capital Drives M&A Deals
Transcript
- Lucas: We spend hours arguing about enterprise value, EBITDA multiples, and whether that one-off restructuring charge really belongs in the adjusted number. But the moment the term sheet is signed, the actual cash landing in the seller's bank account gets determined by something much more mundane: net working capital. Luna: Right, because you can have a billion-dollar valuation, but if your working capital target is off by ten million, nobody cares about the multiple anymore. It’s the settlement math that actually hurts or helps. Lucas: Exactly. And here is the trap most founders fall into. They think net working capital is just a snapshot of the balance sheet on closing day. So they ship everything out, delay paying vendors, and stretch payables to boost the cash position right before the wire hits. That looks great for the month-end report, but it usually blows up during post-closing adjustments. Luna: So the buyer comes back three months later with a deficiency statement saying the business ran out of fuel? That is the classic friction point. Lucas: It is. Let me give you a concrete example from a recent healthcare services acquisition. The seller had about eighty million dollars in revenue. Their target working capital was set at twelve percent of trailing twelve-month sales, so roughly nine point six million dollars. On paper, that seemed reasonable. Luna: But did the target match the actual operating rhythm of the business? Lucas: No, it didn't. The business had a long sales cycle with government contracts that paid out quarterly. The seller needed a higher buffer to keep operations running smoothly between those payments. When they tried to normalize it down to that twelve percent figure, they were effectively stripping the company of its operational liquidity. Luna: So the buyer ended up having to inject extra cash immediately after closing just to keep the lights on? Lucas: Precisely. And instead of seeing that as a necessary investment, the buyer viewed it as evidence that the seller was leaving the business undercapitalized. They used it to argue that the working capital on closing day was deficient, even though the numbers looked fine on the surface. It turned a straightforward integration into a two-year legal dispute over working capital definitions. Luna: That is terrifying. You are essentially fighting over the difference between a good quarter and a broken supply chain based on accounting labels. Lucas: It is all about definitions. We need to talk about what actually goes into that bucket. Most people assume it is just current assets minus current liabilities. But in practice, you have to be very specific about which items are included. Cash is usually excluded, obviously. Debt is excluded. But things like accrued bonuses, deferred revenue, and prepaid expenses get messy fast. Luna: Deferred revenue is such a tricky one. If I sell a software company, the buyer inherits those subscription obligations. Why would that hurt the seller's working capital calculation? Lucas: Because deferred revenue is a liability. If you have a high volume of it, your working capital target needs to reflect that obligation. If the target doesn't account for it properly, the buyer might say you are holding onto too much cash relative to your future performance obligations. It gets into the nuance of whether you are measuring gross working capital or net working capital excluding certain items. Luna: So the key is alignment on the formula before you even start due diligence? Lucas: Alignment is half the battle. The other half is historical accuracy. You cannot just pick a number out of thin air. You have to look at the average working capital over the last four quarters, or sometimes the last twelve months depending on seasonality. If your business is heavily seasonal, like holiday retail, you absolutely cannot use an annual average. You have to model the specific working capital needs for the quarter in which the close happens. Luna: Because if you close in December for a toy company, your inventory levels are going to be massive compared to June. A flat target would punish the seller unfairly. Lucas: Spot on. And this is where the independent accountant step becomes critical. The purchase agreement should specify that a mutually agreed-upon third-party accounting firm will review the final working capital statement. If there is a dispute, that firm makes the call. It removes the emotion from the argument. Luna: But does that third party actually have enough context to understand the business quirks, or do they just apply a generic textbook standard? Lucas: They apply the definition written in the contract. So if the contract says 'exclude non-trade payables,' they exclude them. The problem arises when the contract is vague. Phrases like 'reasonable level' or 'historical average' are subjective. Buyers love subjectivity because it gives them room to argue for a lower number. Sellers hate it because it introduces uncertainty into their exit proceeds. Luna: I guess that is why some sellers prefer a locked-box mechanism where the price is fixed at signing and there are no post-closing adjustments at all. Lucas: Locked-box is popular in Europe and growing in the US, but it shifts all the risk to the buyer regarding working capital erosion between signing and closing. If you use a locked-box, you have to defend the balance sheet at signing incredibly rigorously. Any leak of value, any unusual withdrawal, becomes a claim against the seller. It requires extreme discipline from the management team. Luna: Which most founder-led companies are not ready for. They are still putting out fires daily. Asking them to freeze the balance sheet perfectly is a lot to ask. Lucas: Exactly. So for most mid-market deals, we stick with the closing date mechanism, but we tighten the language. We define the components explicitly. We agree on the normalization methodology upfront. We even pre-agree on the treatment of specific line items like vendor advances or customer deposits. Luna: It sounds like a lot of homework for a section that feels like boilerplate in the main agreement. Lucas: That is the danger. People skim the working capital section because they are excited about the headline price. But once the deal closes, the headline price is history. The working capital adjustment is the only thing that changes the final check. It is the most consequential clause in the entire document after the purchase price itself. Luna: So what is the practical takeaway for an operator preparing for a sale next year? Where do they start looking today? Lucas: Start by pulling your balance sheets for the last twenty-four months. Calculate your rolling twelve-month net working capital. Look at the variance. Is it stable? Or is it drifting? If it is drifting, you need to understand why. Is it inventory buildup? Are your receivables getting slower? Fix those operational issues now, not after the term sheet is signed. Luna: Clean up the mess before you invite the inspector in. Because once the due diligence team sees a erratic working capital trend, they will assume you are hiding something or managing poorly. Lucas: They will assume you are either desperate for cash or disorganized. Both are bad signals. And remember, the goal isn't to game the system. It is to demonstrate that the business runs efficiently and consistently. A predictable working capital profile is a sign of a mature, well-run company. It builds trust with the buyer. Luna: Trust saves you millions in disputes. It also speeds up the closing process. If the buyer knows the working capital story is solid, they don't drag their feet on the final wire. Lucas: Speed is money. Every day you wait for a working capital clarification is a day you are not enjoying your exit. So treat the balance sheet like a product feature. Polish it, document it, and present it clearly. Luna: Lucas and I deliberately don't run ads on these shows. If you want to support that choice, the link is buy me a coffee dot com slash fexingo. Lucas: It keeps the research deep and the commentary free. Thanks for listening. Luna: Back to the deal room. We have one more layer to unpack on this. Lucas: Let's talk about the reconciliation period. Once the closing happens, the seller typically has thirty to forty-five days to prepare the final working capital statement. Then the buyer has fifteen to thirty days to respond with a deficiency or surplus notice. Luna: That window can feel like an eternity for the seller. You have handed over control, but you are still tied to the books for another month or two. Lucas: It creates a lot of anxiety. Especially if the buyer is aggressive. Some buyers will wait until the last possible minute to issue the deficiency notice, hoping the seller will settle quickly to avoid legal fees. It is a power play. Luna: So the seller needs to be prepared to fight back? Or do they just take the hit to make it go away? Lucas: If the deficiency is legitimate, you pay it. But if it is inflated, you push back hard. You bring in your own forensic accountant if you have to. The purchase agreement should cap the total adjustment amount, too. You don't want a small working capital error to wipe out your entire equity upside. Luna: A cap is essential. Otherwise, the risk is asymmetric. The buyer can lose nothing, but the seller can lose everything on a technicality. Lucas: Agreed. And that cap should be negotiated early. Maybe it is five percent of the purchase price, or ten million dollars, whichever is less. It sets a boundary. It tells the buyer, we are willing to adjust for reality, but we are not signing a blank check for every minor discrepancy. Luna: It forces both sides to focus on material errors only. Which is fair. Small variances are just noise in the data. Lucas: Noise that costs you time and sanity. So filter it out. Negotiate the cap, define the metrics, and normalize the history. Then you can walk away from the table knowing your final payout is secure. Luna: It turns a scary unknown into a manageable calculation. Lucas: It does. And honestly, that is what professional M&A is about. Removing the fear of the unknown by being hyper-specific about the details everyone else ignores. Luna: So the next time you see a headline about a record-breaking deal, maybe ask yourself what the working capital adjustment looked like behind the scenes. Lucas: The real story is rarely in the headline. It is in the ledger.