Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The M&A Purchase Price Adjustment Trap That Cost a Seller $8 Million
Transcript
- Lucas: Let's talk about the purchase price adjustment that cost a medical device founder eight million dollars. Luna: Eight million — that's not a rounding error. What happened? Lucas: So the company was a Midwest-based manufacturer of surgical instruments, doing about forty million in revenue. Private equity buyer, a carve-out from a larger platform. Standard stuff on paper. Luna: Standard until it wasn't. Lucas: Right. The deal used a completion accounts mechanism — that means the purchase price gets trued up after closing based on a post-closing balance sheet. The seller's enterprise value was thirty million, but the actual cash they'd walk away with depended on the working capital peg. Lucas: The working capital target was set at four million dollars. That's the number both sides agreed represented 'normal' working capital for the business. If the closing balance sheet showed more than four million, the buyer would pay the seller the excess. If it showed less, the seller would owe the buyer the shortfall. Luna: So on its face, that sounds fair. Seller gets upside if they've built up inventory or receivables, buyer gets protected if working capital is lean. Lucas: Exactly. And the seller's team — they were smart, but they were operators, not deal lawyers. They focused on the enterprise value, the earnout, the non-compete. The working capital definition got less scrutiny than it deserved. Luna: And that's where the trap was hiding. Lucas: Specifically in how the buyer defined 'inventory.' The SPA said inventory would be valued at the lower of cost or net realizable value, consistent with GAAP. Fine. But it also included a schedule of 'excluded items' — and one of those items was 'excess and obsolete inventory determined in accordance with the buyer's standard policy.' Luna: I can already see where this is going. The buyer's standard policy — not defined anywhere in the agreement. Lucas: Precisely. So the buyer closed, did their completion accounts, and determined that two million dollars of the seller's inventory was 'excess' based on their internal policy. They excluded it from working capital. The seller's working capital dropped from six million to four million — right at the peg. No excess payment. Luna: Wait, but that's only two million. You said eight. Lucas: Because that was just the inventory line. The same policy — undefined 'buyer standard' — was applied to receivables. The buyer had a policy of reserving against any receivable over ninety days. The seller had been carrying some older receivables from a big hospital chain that always paid, just slowly. Under the seller's own accounting, they'd reserved about three percent. The buyer's policy reserved fifty percent. Luna: Fifty percent — that's aggressive for healthcare receivables. Lucas: It's not standard, but the SPA didn't specify which side's methodology governed. It just said 'consistent with past practice' — but whose past practice? The buyer argued that after closing, they were applying their own standard. The seller's counsel tried to fight it, but the dispute resolution clause required them to pay for an independent accountant, and the accountant could only rule on 'manifest error' — not on reasonableness of methodology. Luna: So the seller was stuck. The inventory reclassification cost two million, the receivables reserve reclassification cost another three million, and then the same logic hit the payables — the buyer accelerated some payables to reduce working capital. Lucas: Right. Total adjustment: eight million dollars the seller had to wire back to the buyer. The founder had already spent some of that money, paid taxes, made distributions to key employees. He had to borrow personally to fund the repayment. Luna: This is the kind of thing that makes operators hate M&A. You sell your company, you think you have a number, and then six months later you're writing a check back. Lucas: And the worst part — the buyer's behavior was technically within the four corners of the contract. The seller's team had agreed to the language. So what could the seller have done differently? Luna: Let me guess: lock down the accounting methodology in the SPA. Lucas: First thing. The working capital definition should reference a specific, pre-agreed set of accounting principles — ideally the same principles the seller used in their most recent audited financials. And the schedule of excluded items should be exhaustive, not refer to an undefined 'policy.' Lucas: Second, the dispute resolution clause needs to allow an independent accountant to rule on the reasonableness of methodologies, not just manifest error. If the buyer applies a fifty percent reserve on receivables, the accountant should be able to say 'that's not reasonable in this industry.' Luna: And third — don't let the buyer prepare the completion accounts unilaterally. The seller should have the right to review and approve the accounting before it's final. Lucas: Yeah, or at least have a joint preparation process. In this deal, the buyer prepared the accounts, sent them to the seller, and the seller had thirty days to object. But because the methodology wasn't locked, the seller's objections were all overridden as 'disagreements on methodology.' Luna: So the seller's lesson is: the purchase price adjustment isn't just a financial exercise — it's a legal document that can shift millions. Lucas: Exactly. And it's worth spending the extra legal fees to get a working capital expert involved during negotiation, not just during the dispute. A good expert would have flagged the undefined policy language and insisted on a schedule of accounting principles. Luna: If these conversations have saved you even a fraction of that kind of headache, it's worth remembering that listener support is what keeps this show ad-free and independent. If today's episode moved your work forward, the smallest way to keep it going is buy me a coffee dot com slash fexingo. Lucas: Yeah, genuinely — that link lets us keep digging into the specific deal mechanics that don't make it into the textbooks. Now, back to that medical device deal — there's one more nuance that cost the seller another layer of pain. Luna: What's that? Lucas: The timing of the adjustment. The SPA said the completion accounts would be delivered within ninety days after closing. The buyer took the full ninety days — and during that period, the seller couldn't access the company's financial systems anymore. They had no way to independently verify the buyer's numbers. Luna: So they were flying blind. The buyer could effectively dictate the outcome. Lucas: Right. The seller's remedy was to hire a forensic accountant to reconstruct the closing balance sheet from scratch — but by then the ninety days had passed, and the buyer had already wired out the adjustment from escrow. The seller had to sue to get the money back, which cost another half million in legal fees. Luna: That's the nightmare scenario. So the fix would be to require the buyer to provide interim drafts of the completion accounts, with seller access to the underlying data. Lucas: Exactly. And a shorter delivery period — forty-five days, not ninety. The longer the buyer has, the more they can massage the numbers. Lucas: There's also a structural alternative that's becoming more common in the lower middle market: the locked-box mechanism. Instead of a post-closing adjustment, the price is fixed at signing, and the seller keeps the cash in the business until closing. The buyer gets the benefit of that cash, but the price doesn't change. Luna: Locked-box avoids the adjustment dispute entirely, but it has its own risks — the seller has to be careful not to leak value between signing and closing. Lucas: Right. Leakage provisions become the new battlefield. But for sellers who want certainty, locked-box can be attractive. The trade-off is that buyers will typically offer a lower price to account for the risk that working capital might be higher than expected. Luna: So the takeaway for our listeners: if you're selling, don't let the purchase price adjustment be an afterthought. Spend the time to define every term, lock the methodology, and keep access to the data. Lucas: And if you're a buyer — obviously you can exploit these gaps, but think about the reputational cost. Private equity firms that develop a reputation for aggressive post-closing adjustments will find it harder to win deals. The best buyers use clean, fair adjustments as a competitive advantage. Luna: That's a good point. In the end, this eight million dollar mistake wasn't really about the money — it was about the founder trusting the process without verifying the details. Lucas: And that's the real lesson. M&A is a game of precision. The big numbers get all the attention, but the small words in the working capital definition are where deals are won or lost.