Latest / The Buyer & Seller Podcast with Fexingo: Business Brokers, Exits, and Private Sales Explained / The Working Capital Adjustment That Cost a Seller 600k
Transcript
- Lucas: Luna, I want to talk about a clause that's buried deep in almost every business purchase agreement and it quietly costs sellers hundreds of thousands of dollars — the working capital adjustment. Luna: Oh, that one. I've heard brokers call it 'the thing nobody explains until the wire transfer doesn't match the letter of intent.' Lucas: Exactly. And it's not malicious — buyers aren't trying to cheat. But if you don't understand how the target is set, you can leave a lot of money on the table. Let me give you a real example. A client of mine sold a mid-sized industrial supply company — about $35 million in revenue, $12 million purchase price. The buyer proposed a working capital target of $4.2 million. The seller said fine, signed the LOI, went through due diligence. Luna: And then what happened at closing? Lucas: They did the final balance sheet. Actual working capital was $3.6 million. So the purchase price got reduced by $600,000. The seller was furious — he thought he'd get the full $12 million. But the contract said the price adjusts dollar for dollar for any shortfall below the target. Luna: Six hundred grand. That's a real hit. What caused the gap? Lucas: Mainly inventory. The seller had let his inventory age — about $800,000 worth was over ninety days old. In his normal course of business, that was still sellable, but under GAAP, working capital accounting treats old inventory differently. The buyer's accountants applied a reserve, and boom — the number dropped. Luna: So the working capital adjustment is basically a closing-date true-up to make sure the seller delivers the business with the same level of net current assets that the buyer assumed when they set the price. Lucas: That's exactly right. Think of it as a promise: 'At closing, the company will have at least X dollars of current assets minus current liabilities.' If it has less, the buyer pays less because they have to inject cash or take on debt to keep operations running. If it has more, the seller gets extra — though that's rarer, because buyers tend to set targets conservatively. Luna: How is the target typically set? Is it just the historical average? Lucas: Usually it's the average of the last twelve months, or sometimes a specific point in time that's considered 'normal.' But here's the trap — if the business has been growing and the seller has been investing in inventory to support that growth, the trailing average will be lower than what's actually on the books at closing. The buyer gets the benefit of that investment for free. Luna: So a fast-growing business that's been ramping up inventory is actually penalized by a trailing average target. Lucas: Exactly. The seller should negotiate a target that reflects the actual working capital needed to run the business at the time of sale — not an average from a period when the company was smaller. Or at least ask for an adjustment if the closing date is during a seasonal peak. I've seen a landscaping company lose $200,000 because they closed in April instead of December. Luna: Because in April they've stocked up on plants and fertilizer, so working capital is high. But the target was based on a twelve-month average that included the winter lows. Lucas: Right. And the buyer's argument is always: 'We're buying a going concern. It should have the working capital to operate normally.' But 'normal' is what you negotiate. The seller's best defense is to have clean, normalized financials and to model the adjustment with their CPA before signing the LOI. Luna: What about receivables? That's another common flashpoint, isn't it? Lucas: Huge. If the seller has a lot of old receivables — say over 90 days — the buyer will often insist on excluding them from working capital or discounting them. One manufacturing client had $1.2 million in receivables, but $300,000 of it was over 120 days. The buyer wanted to exclude that entire $300,000. The seller argued they were collectible. They compromised: a 50 percent reserve, so only $150,000 counted. That alone reduced the working capital by $150,000. Luna: So the cleaner the balance sheet — the less old inventory, the less old receivables — the better the seller's position. Lucas: Absolutely. I tell every seller: six months before you plan to sell, start cleaning up your working capital. Collect old receivables. Sell off stale inventory. Don't stock up on raw materials unless you have to. And absolutely do not let your payables get too low — because if you pay down your payables right before closing, your working capital actually goes up, which sounds good, but then the buyer sees a spike and questions whether it's sustainable. Luna: Wait — paying down payables increases working capital? Let me make sure I follow: working capital is current assets minus current liabilities. Payables are a current liability. If you pay them down, liabilities go down, so working capital goes up. Lucas: You've got it. So a seller who pays off all their vendors right before closing actually inflates working capital. The buyer will often normalize that and say: 'Your true sustainable working capital is lower.' And then they set a lower target. Luna: So you really can't win by trying to game the balance sheet. The best approach is to run the business normally and then negotiate a fair target based on what the business actually needs. Lucas: Exactly. And that's why you need a good advisor — a broker or an M&A attorney who's seen these adjustments play out. The working capital clause is usually one page in a hundred-page agreement, but it can swing the final price by five to ten percent easily. Luna: Lucas, before we go deeper into the mechanics, I want to mention something that relates to what you just said about needing good advisors. A lot of listeners tell us they've learned more about selling a business from this podcast than from their own accountants or lawyers. Lucas: Yeah, we hear that a lot. And it's the reason we keep making these episodes ad-free. A couple of dollars a month from listeners is genuinely what keeps these going — buy me a coffee dot com slash fexingo, if you've gotten something out of them. It really does make a difference. Luna: Absolutely. Every bit helps us keep the lights on and the content independent. Now, back to working capital — what about the mechanics of the adjustment itself? How is it calculated at closing? Lucas: Typically, the buyer prepares a preliminary closing balance sheet within a few days after closing. They calculate working capital, compare it to the target, and adjust the purchase price. Then the seller has a period — usually 60 to 90 days — to review and dispute. If they can't agree, it goes to an independent accounting firm for resolution. Luna: And that dispute process can be expensive. I've heard of disputes costing $50,000 or more in accounting and legal fees. Lucas: Easily. And the loser often pays. So it's in both parties' interest to define the items clearly upfront. What's included in working capital? Cash? Typically excluded. Debt? Usually excluded. But what about deferred revenue? Customer deposits? Prepaid expenses? Each one is a negotiation. Luna: What's the one thing you'd tell a seller who's about to sign an LOI with a working capital target? Lucas: Model it. Take your actual balance sheet as of today, apply the target definition from the LOI, and see what the adjustment would be. Then ask: 'If I close three months from now, what does that number look like?' If you're growing and need more inventory, the gap widens. If you're shrinking, it narrows. You need to know that before you agree to a fixed target. Luna: And if the buyer won't budge on the target? Lucas: Then consider a working capital collar — a range. Say the target is $4 million with a collar of plus or minus $200,000. If actual is within that range, no adjustment. That protects the seller from small fluctuations. Or negotiate a fixed-dollar amount that the buyer will accept as a true-up — like 'if working capital is below $3.8 million, buyer pays the difference; if above $4.2 million, seller pays.' It's all negotiable. Luna: So it's not just a boilerplate number. It's a real lever. Lucas: It is. And the best time to pull that lever is before you sign the LOI, not after. Once the LOI is signed, the buyer has the leverage. They can say, 'We've already agreed on the price. This is just a mechanics issue.' But it's not just mechanics — it's economics. Luna: Great advice. Thanks, Lucas. Lucas: Next time, we'll talk about indemnification caps and baskets — another seemingly minor clause that can cost sellers millions. Until then.