Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Working Capital Target Trap That Shrinks M&A Payouts
Transcript
- Lucas: You know that moment in a business sale when you shake hands on the purchase price — let's say twelve million dollars — and you think you've basically locked in your payout? And then the buyer's lawyer sends over the draft purchase agreement and buried in a schedule is something called the 'working capital target.' Luna: Oh, the target. Yeah — that's one of those line items sellers glaze over because it sounds like accounting housekeeping. Lucas: Exactly right. And that's exactly how a friend of mine — let's call him Mark — lost over a million dollars on a deal last year. Mark ran a Midwest industrial distribution company, about forty million in revenue. He got a letter of intent at twelve times EBITDA, twelve million bucks. He thought he was home free. Luna: And then the working capital target clause took a bite out of his proceeds. Lucas: A big bite. The LOI said 'net working capital target to be defined in the definitive agreement.' Standard language. Mark's lawyer flagged it, but Mark figured — we've got about six million in receivables plus inventory, minus payables, net working capital is maybe three-point-five million. He assumed the buyer would use that number as the peg. Luna: But the buyer didn't. Lucas: The buyer set the working capital target at two-point-three million. Their reasoning: they took Mark's trailing twelve-month average net working capital, which happened to be lower because the company had a seasonal inventory build in Q4 that wasn't typical. They excluded that spike. So their 'normalized' target was over a million dollars lower than what Mark actually needed to run the business. Luna: And at closing, if actual working capital exceeds the target, the seller gets paid more. But here, Mark's actual working capital was three-point-five million, target was two-point-three million — so the buyer owes him the difference? Lucas: That's what Mark expected. But here's the kicker: the purchase agreement said that if actual working capital at closing is above the target, the excess is treated as 'excess cash' and the seller gets dollar for dollar. If actual is below target, seller writes a check. But the buyer's definition of 'cash' excluded the receivables that were over ninety days old — about eight hundred grand. And they also excluded a line of inventory they deemed slow-moving. Luna: So the buyer effectively shrank the working capital calculation from both ends. Lower target, and then a narrower definition of what counts. Lucas: Exactly. Mark's team calculated actual net working capital at closing at three-point-five million. The buyer recalculated it at two-point-six million, after exclusions. So the buyer claimed the excess was only three hundred thousand, not one-point-two million. Mark ended up with a post-closing dispute that took nine months to settle — and he netted about two hundred thousand extra, not the million-plus he thought he was owed. Luna: That is brutal. So what could Mark have done differently? Lucas: First, he should have negotiated the working capital target definition in the LOI, not left it for the definitive agreement. If the LOI says 'net working capital target of three-point-five million,' that's a much harder number for the buyer to move later. Second, he needed to define exactly which accounts receivable and inventory are included — age buckets, slow-moving thresholds, all of it. Luna: And the calculation methodology. Is it trailing twelve-month average? Last quarter? A fixed number? Lucas: Right. The most seller-friendly approach is a fixed target — a specific dollar amount agreed upfront. The buyer will push for a formula based on historical averages, because that gives them wiggle room. Mark's deal used a trailing twelve-month average, which the buyer then adjusted for 'unusual items.' That's the loophole. Luna: So if you're a seller, what do you ask for specifically? Lucas: You want a fixed working capital target, say three-point-five million, with a 'true-up collar' — meaning if actual working capital at closing is within, say, two hundred thousand of the target, no adjustment. If it's outside that band, adjustment kicks in dollar for dollar based on a mutually agreed definition of current assets and liabilities. And you get that definition spelled out in an exhibit, with examples. Luna: The collar protects against small fluctuations that aren't worth fighting over, but gives the seller upside if the business is growing. Lucas: Exactly. Now, another thing: the working capital target is often used as a backdoor way for buyers to finance part of the purchase price. If they set the target artificially low, they effectively get a discount. Because the seller has to contribute working capital at closing — essentially leaving money in the business. Luna: So the buyer isn't paying twelve million; they're paying eleven million plus expecting the seller to leave a million in working capital. Lucas: Right. That's why the working capital target should be set at the level needed to run the business post-close, not at some historical low point. A good rule of thumb: calculate the average net working capital over the prior twelve months using the same definitions the buyer will apply. Then add a small buffer for seasonality. Luna: And have your own auditor run a mock calculation before signing. Lucas: Absolutely. Mark's biggest mistake was trusting that 'standard' language meant his number. It never does. The working capital target is one of the most negotiated line items in the purchase agreement, and it directly affects your proceeds at closing. Luna: This is exactly the kind of thing that makes you realize how much diligence goes into the fine print. If listeners found this helpful, we should mention — the way these episodes stay ad-free and available to everyone is through listener support at buy me a coffee dot com slash fexingo. No pressure, just if you get value, that's how it keeps going. Lucas: Absolutely. And we're grateful for that. So back to working capital — there's another trap I want to flag: the 'cash and cash equivalents' definition. Luna: What's the trap there? Lucas: Buyers often exclude restricted cash, security deposits, and sometimes even bank accounts that aren't part of the company's primary operating accounts. So if you have a separate account for a self-insured health plan or a 401k matching reserve, that might not count as cash. That can reduce your working capital calculation. Luna: So you want to make sure all cash accounts that are freely usable are included. Lucas: Right. And debt definitions too. Sometimes buyers define debt to include deferred revenue, accrued bonuses, or even operating leases. That inflates liabilities, which reduces net working capital. You want debt to mean only interest-bearing obligations — not normal operating liabilities. Luna: It sounds like the working capital target clause is really a bundle of hidden definitions. Lucas: It is. And the way to handle it is to hand your M&A attorney a spreadsheet with your own calculation before they ever see the buyer's draft. That way, when the buyer's definition comes in, you have a baseline to compare. You can say, 'Our calculation shows net working capital of three-point-five million. Your definition yields two-point-six. Let's reconcile the differences.' Luna: And that reconciliation should happen before signing, not after. Lucas: Exactly. Once you sign, the buyer has the leverage. So the lesson from Mark's deal: the working capital target is not a technical detail — it's a million-dollar line item. Treat it that way. Luna: And if you're listening and you've got a deal coming up, maybe run your own numbers this week. Lucas: Good advice. Next episode, we're going to talk about another clause that looks harmless but can sink a seller: the 'ordinary course of business' covenant. That one can freeze your operations between signing and closing. Luna: Looking forward to it. Until then, keep your eyes on the working capital target.