Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The M&A Working Capital True Up That Cost a Seller $3 Million
Transcript
- Lucas: So let me start with a number: three million dollars. That's what a seller in a $40 million manufacturing deal lost because of a working capital true-up clause they barely read. Luna: Ouch. And I bet they thought they were getting paid that three million on day one. Lucas: Exactly. They saw a $40 million purchase price and assumed that was the wire amount. But in most private company acquisitions, the purchase price is actually 'subject to a working capital adjustment.' And that adjustment can go either way — but in this case, it went straight against the seller. Luna: Walk me through how that works. Because I think a lot of founders hear 'working capital true-up' and kind of glaze over. Lucas: Sure. So the basic idea is: the buyer and seller agree on a target level of working capital — usually defined as current assets minus current liabilities, but with carve-outs. The target is typically based on the company's historical average over the trailing twelve months. Then, at closing, the seller delivers a closing working capital statement. If the closing number is above the target, the buyer pays the seller the difference. If it's below, the seller owes the buyer. Luna: Right. So in theory, it's fair. The seller gets compensated for any extra cash or receivables they left in the business. Lucas: In theory. But in practice, the definition of 'working capital' is where the traps live. In the case I mentioned, the seller had aggressive revenue recognition — they booked revenue on shipments that technically hadn't cleared the customer's dock yet. So their receivables were inflated. The buyer's auditors flagged that, and under the definition in the purchase agreement, those receivables didn't count. The seller's closing working capital came in three million below the target. Luna: So the seller had to write a check for three million at closing? That's brutal. Lucas: Worse — they didn't get a check. They had a note payable. The buyer just deducted it from the purchase price. So the seller walked away with $37 million instead of $40 million, and the earnout they had was based on post-close earnings, which were lower because they'd already lost that cash. Luna: It's a double hit. They lose the three million upfront, and then the earnout underperforms because the business has less working capital to operate with. Lucas: Exactly. And this is so common. I've seen working capital adjustments swing by 5 to 10 percent of the purchase price in middle-market deals. The sellers who negotiate well protect themselves. Luna: What should a seller negotiate, specifically? Lucas: First, audit the definition of working capital line by line. Don't just accept the buyer's template. Second, simulate the true-up under multiple scenarios — what if revenue dips in the month before close? What if a big customer pays late? Third, negotiate a cap on post-close adjustments. And fourth, make sure the target working capital peg is based on a normalized period, not an unusually high or low one. Luna: And if the seller doesn't have a strong CFO, they should hire an independent M&A advisor who specializes in working capital true-ups. That fee is a fraction of what they could lose. Lucas: Yeah, it's a cheap insurance policy. Look, working capital true-ups are one of the most mechanical parts of a deal, but they're also one of the most emotional because the seller sees it as a surprise haircut. Luna: And it doesn't help that the buyer's definition often excludes things like deferred revenue or certain prepaids. The seller thinks they're getting paid for all those assets. Lucas: Right. So let's switch to the earnout interaction — because that's where this gets really painful. Luna: Yeah, you mentioned the earnout was tied to post-close earnings. How does a working capital adjustment affect that? Lucas: If the seller has to return working capital to the buyer, the business has less cash to fund operations. That can depress earnings in the earnout period, especially if the company is growing and needs to invest in inventory or receivables. So the seller not only loses the cash upfront, but they also fail to hit their earnout targets because the business is starved of working capital. Luna: That's a great point. And it's worth noting that earnout periods are often 2–3 years. So the impact compounds. Lucas: Exactly. In the case I mentioned, the seller's earnout was based on EBITDA for two years. The EBITDA targets were aggressive anyway, and with the working capital clawback, they missed year one by a mile. They ended up with zero earnout. Luna: So in total, they lost three million on the adjustment and then another — what, maybe four or five million on the earnout? Lucas: Roughly. The earnout was structured as 6 million possible. They got zero. So total economic loss: about 9 million on a 40 million deal. That's over 20 percent. Luna: Brutal. And completely avoidable if they'd had someone push back on the working capital definition. Lucas: Yeah. And it's not just about the definition. It's also about the timing. Most working capital true-ups are based on the closing balance sheet, which can be gamed. For example, the seller might accelerate collections before closing to boost cash. But the buyer's definition of working capital often excludes cash, so that doesn't help. Or the seller might delay paying vendors — but those payables would reduce working capital, so that actually hurts the seller. Luna: So the seller is really at the mercy of how the target is set. If the target is based on a trailing twelve-month average, the seller can't easily manipulate it. Lucas: Right. And that's actually a fairer approach. But many buyers push for a fixed peg based on a recent month-end, which can be volatile. The seller should push for the trailing twelve-month average, because it smooths out seasonality and one-time events. Luna: Let's talk about the negotiation itself. How do you bring this up without scaring the buyer off? Lucas: You frame it as good governance. You say, 'I want to make sure we have a clear, objective definition so there are no surprises post-close.' No buyer wants surprises either. And you offer to provide a detailed reconciliation of your proposed definition. Most buyers are reasonable if you're transparent. Luna: And if they're not reasonable? Lucas: Then you might have a red flag. If a buyer is unwilling to discuss the working capital definition in detail, they may be planning to use it as a discount tool. In that case, you either walk or you price that risk into your deal price. Luna: Good advice. So to wrap up: if you're selling, don't treat the working capital true-up as boilerplate. It's a multi-million dollar negotiation in disguise. Lucas: And if you're buying, be fair. A seller who feels cheated on the working capital adjustment will fight you on every post-close issue. There's a right way to do it — and it's not about maximizing the clawback. Luna: Well said. Let's leave it there for today. Next episode we'll dig into another trap that's hiding in plain sight.