Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Working Capital True-Up That Cost a Seller $2 Million
Transcript
- Lucas: There's a number in every private-company acquisition that gets less attention than the purchase price, yet it can claw back hundreds of thousands — sometimes millions — from the seller's pocket. I'm talking about the working capital target. Luna: The working capital target. That's the agreed-upon level of net current assets the seller is supposed to deliver at closing, right? Lucas: Exactly. The buyer says, 'We're paying you $50 million, but we expect the company to come with, say, $5 million in net working capital — cash plus receivables plus inventory minus payables and accrued expenses.' If the actual number at closing is lower, the buyer deducts the shortfall from the purchase price. If it's higher, the seller gets a bump. In theory, it's fair. Luna: But in practice, it's where a lot of fights happen. I've seen deals where the working capital target was set using a stale balance sheet, and the seller ended up owing money at closing. Lucas: That's exactly the story I want to walk through. There's a case from last year — a SaaS company with about $8 million in recurring revenue. The buyer proposed a working capital target based on the trailing twelve-month average. The seller's CFO, who wasn't experienced in M&A, agreed. Looked reasonable on paper. Luna: But the trailing average included a period where the company had a large cash prepayment from a multi-year contract. That inflated the average. Lucas: Exactly. So the target got set at $1.2 million. At closing, the actual net working capital was closer to $800,000 because that prepayment had been recognized as revenue and the cash was spent. The buyer did a post-closing true-up and demanded a $400,000 reduction. The seller ended up netting $400,000 less than they expected. Luna: And they had already spent some of that money on a retirement account and a new car. I remember that case. It got ugly. Lucas: Right. But the real disaster was the one I want to focus on today — a deal where the working capital true-up cost the seller $2 million. It's a cautionary tale about what happens when you don't define 'net working capital' carefully enough in the agreement. Luna: Let's hear it. Lucas: This was a manufacturing business — about $50 million in revenue, family-owned. The buyer was a mid-market private equity firm. The LOI proposed a working capital target of $8 million, calculated as current assets minus current liabilities per GAAP. Seemed straightforward. Luna: But there's always a 'but'. Lucas: The but was deferred revenue. The company had a service division that collected annual maintenance contracts upfront. Under GAAP, that cash sat on the balance sheet as a liability — deferred revenue — even though the cash was already in the bank. The buyer's working capital calculation included that deferred revenue as a current liability, which crushed the net working capital number. Luna: So the seller had $3 million in cash from those prepaid contracts, but the buyer counted it as a liability, reducing the working capital by that same amount. Lucas: Exactly. At signing, the trailing balance sheet showed net working capital of $7.5 million against the $8 million target — a $500,000 shortfall. But the real problem came at closing. The company had just collected $4 million in annual renewals. That cash was in the bank, but under the buyer's definition, deferred revenue spiked, so net working capital dropped to $5 million. The true-up demanded a $3 million reduction. Luna: Wait — so the seller had more cash, but the formula said they had less working capital? That's backwards. Lucas: It is, unless you exclude deferred revenue from the definition. The seller didn't catch it. Their lawyer was a general corporate attorney, not an M&A specialist. The purchase agreement defined net working capital using a standard gaap based formula with no exclusions. The buyer's post-closing statement showed a $3 million shortfall. After negotiation, they settled at a $2 million clawback. Luna: So the seller lost $2 million because of an accounting definition. That's brutal. Lucas: And it's not rare. I've seen working capital disputes in nearly a third of the deals I've advised on. The most common fight is over what gets included. Buyers want to include every current liability — especially deferred revenue, accrued bonuses, and litigation reserves. Sellers want to exclude anything that doesn't represent ongoing operational needs. Luna: What about the 'normalizing adjustments'? I've heard that term thrown around. Lucas: That's another huge trap. Buyers will say, 'We need to adjust the working capital target to reflect normal operations.' So they strip out one-time items like a large inventory build for a special project. But they don't add back one-time benefits like a big customer prepayment. It's a one-sided normalization. Luna: So the target gets artificially lowered, and then the seller has to deliver more working capital than the business actually needs. Lucas: Exactly. I saw a deal where the buyer normalized the working capital target by excluding $1.5 million in excess cash from a debt refinancing. That made the target $6 million instead of $7.5 million. Then at closing, the company had $2 million in cash from operations, but the buyer said 'that's normal cash, so it counts.' The seller beat the target by $500,000 and got a small bump. But they had effectively financed the buyer's working capital. Luna: So the buyer got the benefit of the excess cash they excluded from the target. Clever, but predatory. Lucas: Let's talk about the mechanics of the true-up itself. In most deals, the buyer prepares a closing statement within 60 to 90 days after close. The seller gets to review it, but the agreement usually says the buyer's statement is binding unless the seller objects within a short window — often 30 days. And the objection process is expensive: you need an independent accountant, and the costs are split. Luna: So the seller has to spend tens of thousands on an accountant just to challenge a number that might be off by a few hundred thousand. That creates a chilling effect. Lucas: Exactly. In the manufacturing deal I mentioned, the seller's accountant estimated it would cost $80,000 to $100,000 to fight the $3 million claim. The seller didn't have that kind of cash post-close — they had already paid taxes on the sale and set aside money for retirement. So they settled for $2 million just to avoid the fight. Luna: What's the single most important protection a seller can put in the agreement to avoid this? Lucas: A fixed-dollar cap on post-closing adjustments, tied to a jointly prepared closing balance sheet. Not a buyer-prepared statement with a seller review period. You want a mechanism where both parties sign off on the closing balance sheet before the adjustment is calculated. And you want a cap — say, 5 percent of the purchase price — so the adjustment can't wipe out your entire earnout or escrow. Luna: And specifically define what counts as working capital. Exclude deferred revenue, exclude excess cash, exclude any liabilities that aren't operational. Lucas: Yes. And if the buyer won't agree to exclusions, at least get a fixed-dollar working capital target — not a formula based on a trailing period. Say 'The target is $7 million exactly,' not 'The target is the average of the last twelve months.' That prevents the buyer from manipulating the reference period. Luna: So the seller should insist on a specific number, not a moving target. Lucas: Right. And here's another practical tip: include a provision that any dispute over the closing statement goes to a neutral accountant whose decision is binding, but with the loser paying the cost. That gives the buyer a disincentive to inflate the claim. Luna: That's smart. If the buyer knows they'll have to pay the accountant's fees if they lose, they'll think twice before padding the shortfall. Lucas: Exactly. And one more thing — tie the working capital true-up to the escrow. If the buyer can claw back from the escrow, they have no incentive to be reasonable. Instead, structure it so any adjustment above a de minimis threshold — say $50,000 — is paid directly by the buyer or seller, not from escrow. That keeps the escrow for indemnification claims, not working capital disputes. Luna: It's funny — people spend weeks negotiating the purchase price, but the working capital target can undo all that work in an afternoon. Lucas: It really can. And the worst part is, sellers often don't realize they've been burned until months after closing, when they get the buyer's true-up statement. By then, the leverage is gone. You've already signed the release, handed over the keys. The buyer has the cash. Luna: Alright, this feels like a good place to mention something that keeps shows like this going — listener support. If these conversations have helped you think more clearly about your own deal terms, maybe saved you from a costly mistake, a couple of dollars a month is genuinely what keeps these episodes ad-free. You can contribute at buy me a coffee dot com slash fexingo. Lucas: Yeah, every bit helps us keep digging into the specific clauses that cost people real money. And it keeps us independent — no sponsor dictating the topic. So if that matters to you, consider it. Luna: Alright, back to the working capital trap. Lucas, you mentioned the escrow tie-in. Can you walk through a concrete example of how that plays out? Lucas: Sure. Let's say the purchase price is $10 million, with a 10 percent escrow — $1 million held back for 18 months. The buyer claims a $300,000 working capital shortfall. If the agreement says the shortfall is paid from escrow, the seller loses that cash immediately. But if the agreement says the buyer pays the shortfall out of pocket, the seller keeps the escrow for actual indemnification claims — like a tax liability or a customer loss. Luna: So the seller wants the true-up to be a separate wire transfer, not an escrow deduction. Lucas: Exactly. And if the buyer insists on using escrow, then the seller should demand a separate working capital escrow with a shorter hold — say, six months. That way, the indemnification escrow isn't eroded. Luna: It's all about controlling the timing and the leverage. The seller who waits until after closing to fight the working capital number is already behind. Lucas: That's the takeaway. The working capital target isn't a technical accounting detail — it's a real dollar negotiation. Treat it like one. Get a specific number, define what's included, cap the adjustment, and keep the payment separate from the escrow. Do that, and you've closed the biggest loophole in the deal.