Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Working Capital Definition Trap That Cost a Seller 28 Million
Transcript
- Lucas: So there's a deal that closed back in March, a specialty chemicals distributor in the Southeast, and the seller thought they had a clean exit. They walked away with about 28 million less than they expected, and it all came down to three words in the working capital definition: 'in the ordinary course.' Luna: Three words cost them 28 million? That's brutal. What happened exactly? Lucas: Yeah, so the business had a strong seasonal pattern. They'd stockpile inventory in Q4 to meet spring demand from agricultural customers. The buyer was a private equity firm, and they'd defined working capital as 'the amount required to operate the business in the ordinary course.' The seller assumed that meant their typical year-end inventory level, which was high because of the season. Luna: And the buyer read it differently. Lucas: Right. The buyer's accountants looked at the trailing twelve months and said, 'the ordinary course is actually the year-round average, not the seasonal peak.' So they excluded about 40 million of that inventory build from the working capital peg. The seller's EBITDA was solid, but the purchase price was pegged to working capital, so the net adjustment was a 28 million hit to proceeds. Luna: Ouch. And was the seller's legal team asleep? I mean, that seems like something you'd catch in the purchase agreement. Lucas: That's the thing. The seller's counsel was a solo practitioner who didn't specialize in M&A. They focused on the big-ticket items like reps and warranties and indemnification, but the working capital definition is often the most fertile ground for post-closing disputes. And here, the definition was vague enough to be twisted. Luna: So what's the fix? How do you write that definition so it doesn't blow up? Lucas: The first thing is to be incredibly specific about what 'ordinary course' means. You can define it by reference to a specific period, like the last twelve months ending at the most recent fiscal year-end, and then adjust for known changes. But even better, you can avoid the phrase altogether and define working capital items with a precise formula. Luna: Like what? Give me an example. Lucas: So instead of saying 'in the ordinary course,' you might say 'consistent with the historical practices of the company during the twelve months ended December 31, 2025.' And then you attach a schedule that lists every account and how it should be calculated. You can even set a floor or a cap on inventory. The key is to make it so that there's no room for interpretation. Luna: But doesn't the buyer have their own accountants who will try to poke holes anyway? Lucas: Sure, but if the contract is tight, the dispute is limited to factual questions, not definitional ones. And you can also require that the two sides' accountants use the same set of books and records, with no new information. In this case, the buyer's team actually used a different source document — they pulled the bank statements instead of the internal ledger, and that changed the cash balance. Luna: Wait, cash is part of working capital? I thought cash was usually excluded. Lucas: That's another trap. In many deals, cash is excluded and handled separately through a dollar for dollar adjustment to the purchase price. But here, the definition of working capital included 'cash and cash equivalents,' which is common in some industries. The seller thought they'd kept a minimum cash balance in the business, but the buyer argued that the excess cash should have been distributed before closing, so they reduced working capital by that amount. Luna: So the seller got hit twice: once on inventory and once on cash. Lucas: Exactly. And the combined effect was 28 million. It's a classic case of the working capital peg being a moving target. The seller was so focused on the headline EBITDA multiple that they didn't spend enough time on the definition of the peg itself. Luna: I've heard the phrase 'working capital peg' thrown around, but for someone who's not a deal lawyer, what does that actually mean in plain English? Lucas: So the working capital peg is essentially the amount of working capital that the buyer assumes is needed to run the business. If the actual working capital at closing is higher than the peg, the buyer pays the seller the difference. If it's lower, the seller pays the buyer. It's a way to ensure the seller doesn't strip out all the cash or leave the business without enough inventory to operate. Luna: Got it. And in this case, the seller thought the peg would be based on their seasonal peak, but the buyer set it at the average. Lucas: Right. And the problem is that the definition was ambiguous. So the buyer's interpretation, which was arguably reasonable, prevailed in the post-closing dispute resolution — because the contract didn't clearly say otherwise. The seller had to eat the loss. Luna: So what's the practical takeaway for a seller who's not a giant corporation? How do you avoid this? Lucas: First, you need to understand that the working capital definition is a negotiation point, not a boilerplate provision. You should model it under different scenarios: what if inventory is high, what if it's low, what if the buyer tries to exclude a certain item? And then you need to make sure the language is airtight. That means being very specific about what's included and excluded, and also about the accounting principles used. Luna: You mentioned 'same accounting principles' versus 'identical accounting principles' earlier. What's the difference? Lucas: So 'same accounting principles' could mean the same principles that the company used historically, but that leaves some flexibility. 'Identical accounting principles' is stricter; it means literally the same methods, elections, and procedures applied consistently. In this case, the buyer argued that the company had changed its inventory valuation method from FIFO to LIFO a few years back, and that change was baked into the historical numbers. The seller didn't notice that the definition said 'same' instead of 'identical,' so the buyer was able to use the LIFO method to reduce the inventory value. Luna: That's a subtle but massive difference. And it's the kind of thing that can slip by if you're not careful. Lucas: Absolutely. And that's why it's so important to have a specialist review the SPA, not just any lawyer. The cost of bringing in an experienced M&A attorney is a rounding error compared to the potential loss. In this case, the seller's legal fees were probably a few hundred thousand, but they lost 28 million. Luna: So what else can a seller do to protect themselves? You mentioned auditing the opening balance sheet. Lucas: Yeah, that's a big one. You should have your own accountants prepare a 'mock closing statement' based on the most recent month-end, and then run it through the proposed definition. That will show you exactly what the working capital would be under the contract's terms. If it differs from your expectations, you can negotiate adjustments before signing. You can also include a provision that says the buyer can't use any information that wasn't available to the seller at the time of signing — that prevents the buyer from pulling in new data later. Luna: And what about the dispute resolution mechanism? Is it just the accountants battling it out? Lucas: Typically, yes. The contract will say that if the buyer and seller can't agree on the final working capital, it goes to an independent accounting firm, and their decision is binding. But here's the thing: that firm is often instructed to interpret the contract as written, so if the definition is ambiguous, they'll pick the most reasonable interpretation. The seller can't come back and say 'that's not what I meant' — only what the contract says. Luna: So the lesson is: the devil is in the details, and the details are in the definition. Lucas: Exactly. And this isn't just a one-off horror story. I've seen this pattern repeat in so many deals. The working capital definition is probably the most fought-over provision in M&A after reps and warranties. A lot of buyers use it as a negotiation lever. They'll propose a definition that looks standard but is actually skewed in their favor, hoping the seller won't notice until it's too late. Luna: It's almost like the buyer's team is playing chess while the seller is playing checkers. Lucas: That's a good way to put it. And the worst part is that the seller often doesn't realize they've been outmaneuvered until the post-closing statement comes in, and by then, the money is already gone. They've already signed the release, and the only recourse is to sue for breach of contract, which is expensive and uncertain. Luna: So what's your advice for a seller who's about to enter negotiations? What's the first thing they should do? Lucas: The first thing is to get a copy of the purchase agreement as early as possible, and have your accountant and attorney review the working capital definition with a fine-tooth comb. Don't wait until the final draft. You want to understand how the peg is calculated before you even start talking about price. Because if the peg is set too high, it can effectively reduce your purchase price by millions. Luna: And I imagine you should also consider whether to include a minimum or maximum working capital adjustment. Lucas: Right. You can negotiate a collar, where the adjustment only kicks in if the difference exceeds a certain threshold. That way, minor fluctuations don't trigger a dispute. But you have to be careful not to make it too high, or the buyer will walk away. Luna: So in this specific case, could the seller have done anything to avoid the 28 million hit, or was it already too late once they signed? Lucas: Once they signed, it was probably too late. They had a chance during due diligence to push back on the definition, but they didn't. They were so focused on the multiple that they overlooked the peg. And that's the tragedy — it's a completely avoidable mistake. You just need to spend the time and money to get it right. Luna: It reminds me of that saying: 'an ounce of prevention is worth a pound of cure.' Lucas: Perfectly put. And it's an ounce that costs maybe fifty thousand in professional fees, but it saves you millions. It's one of the few places in M&A where a small investment can have a huge return. Luna: And I have to say, this episode is a perfect example of why we do this show — to help operators avoid these landmines. Lucas: Yeah, and honestly, we wouldn't be able to keep making these deep-dives without the support of our listeners. A small group of folks chip in monthly through buy me a coffee dot com slash fexingo, and that's what keeps this show ad-free and independent. It's not a big ask, but it makes a real difference. Luna: Yeah, it really does. And if you've gotten value out of these episodes, consider joining them. It's a simple way to say thanks. Lucas: So back to the working capital trap — if you're a seller, I can't stress enough: get your own accountant involved early. Don't rely on the buyer's numbers. And if you see the words 'ordinary course' without any specifics, that's a red flag. Luna: And if you're a buyer, this case shows how a well-crafted definition can save you money. But if you push it too far, you risk killing the deal or facing a lawsuit. So there's a balance. Lucas: Absolutely. The goal is to have a working capital definition that both sides understand and agree on, so that the closing goes smoothly. Because the last thing you want is for the deal to feel like a win on day one, only to turn into a costly dispute a month later. Luna: Well said. And on that note, I think we've given our listeners a lot to think about. Next time they're at the negotiating table, they'll know exactly what to look for. Lucas: Exactly. And that's what we're here for. Until next time, keep your definitions tight and your eyes on the peg.