Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Working Capital False Peg That Cost a Seller 30 Million
Transcript
- Lucas: So we've talked a lot about earnouts and escrows and even the occasional MAC clause, but there's one line item in every purchase agreement that I think gets less attention than it deserves, and it's quietly cost sellers more than any single earnout we've covered. Luna: Let me guess — working capital? Lucas: Bingo. The working capital peg. And I've got a specific case: a SaaS company, about forty million in revenue, sold for two hundred and fifty million. The seller walked away thinking they'd nailed a great multiple. Luna: But they didn't. Lucas: They walked away with two hundred and twenty. Thirty million just evaporated because of how the working capital peg was defined. And it's not even an exotic clause — it's in virtually every deal. Luna: So what went wrong? The definition seemed standard? Lucas: It was standard — that was the problem. The buyer defined working capital as current assets minus current liabilities, excluding cash and debt. Sounds harmless. But then they excluded deferred revenue from the liabilities side. Luna: Wait, that's a huge deal for a SaaS company. Deferred revenue is essentially the liability for services you haven't delivered yet. Lucas: Right. And the seller had about thirty million in deferred revenue on the books. By excluding it, the buyer artificially lowered the working capital at closing, which meant the seller had to make a massive post-closing payment to bring it up to the target. Luna: So the seller lost exactly the amount of deferred revenue. Thirty million. It's almost too clean. Lucas: It is. And the worst part is, the seller's advisors didn't catch it because the definition was framed as 'consistent with past practice.' The company had historically excluded deferred revenue when calculating working capital internally, so the buyer argued it was fine. Luna: But excluding it internally for management purposes is not the same as excluding it from a purchase price adjustment. Lucas: Exactly. That's the trap. 'Consistent with past practice' is one of the most dangerous phrases in an entire purchase agreement, because it lets the buyer import whatever accounting quirks they want if the seller's own books had them. Luna: And this wasn't even an earnout — it was a straight adjustment. The seller thought they were getting two fifty, but the working capital peg was set artificially low. Lucas: Let's break down the mechanics, because that's where the real lesson is. In a typical deal, the purchase price is set on a cash-free, debt-free basis, and then adjusted for working capital. The buyer and seller agree on a target level of working capital — the peg. Luna: At closing, you measure actual working capital, and if it's above the target, the seller gets a bump. If it's below, the seller pays the difference. Lucas: Right. So if the buyer can make the definition narrower — excluding deferred revenue, or certain receivables, or even including a weird liability — they lower the baseline. That means at closing, the actual working capital looks lower, and the seller has to write a check. Luna: In this case, the seller had to write a thirty-million-dollar check. That's not a rounding error. Lucas: And the kicker is, the seller's own CFO had signed off on the definition because their internal metrics also excluded deferred revenue. They never stopped to think that this was a contract, not a management dashboard. Luna: So what's the fix? How do sellers protect themselves? Lucas: First, you need to define working capital explicitly in the purchase agreement, and I don't mean a formula. I mean a line-by-line schedule of exactly which accounts are included and which are excluded. Luna: And it should mirror the actual balance sheet, right? Not some idealized version. Lucas: Exactly. The buyer will push for a definition that excludes items that are volatile or that they don't want to pay for, like deferred revenue or certain accrued liabilities. The seller's job is to make the definition match the economics of the business as it's actually run. Luna: And then there's the timing. The peg can be set at signing or at closing, and that matters too. Lucas: Right. If the business is seasonal, a peg based on a historical average might be way off from what's actually on the books at closing. The seller could be giving up millions just because of the calendar. Luna: And what about the 'past practice' language? Should sellers just refuse to include it? Lucas: You can't always refuse it, but you can qualify it. Say 'consistent with past practice, as reflected in the company's audited financial statements for the most recent fiscal year.' That ties it to something objective, not just whatever the CFO happened to do. Luna: So the lesson is: every dollar of working capital is a dollar of the purchase price. Sounds obvious, but it's easy to lose sight of. Lucas: And that's why we spend so much time on these clauses. Because they're not boilerplate — they're where the real money moves. And it's not just deferred revenue. We've seen traps with accounts receivable, inventory, even prepaid expenses. Luna: Give me another example. Something that surprised you. Lucas: A manufacturing company — let's call it a parts maker — had a big contract with a customer that required them to keep a certain level of safety stock. That inventory was essentially reserved for that contract, but it was included in working capital. The buyer, of course, wanted it excluded. Luna: Because they didn't want to pay for inventory that they couldn't sell to anyone else? Lucas: Exactly. So the buyer proposed a working capital definition that excluded 'inventory held for specific customer contracts.' The seller, thinking it was only a small portion, agreed. Turns out that contract was thirty percent of their inventory value. Luna: Ouch. That's a classic 'we thought it was minor' moment. Lucas: And the seller lost about eight million in that case. Not as dramatic as the thirty, but still real. The point is, you need to go through every line item on your balance sheet and ask: is this included or excluded? And what's the dollar impact? Luna: It's like a treasure hunt, but you're looking for the traps, not the treasure. Lucas: And the best defense is to model it out. Run a scenario where you close at the end of each quarter, and see what the working capital adjustment would be under the proposed definition. That should be a standard part of due diligence — for the seller. Luna: But most sellers don't do that. They rely on their advisors, and even then, advisors sometimes miss these things. Lucas: That's why I always recommend sellers bring in a dedicated M&A advisor — someone who's done deals, not just a general corporate lawyer. The nuances here are real. Luna: So if you're listening and you're thinking about selling your company, what's the one thing you should do today? Lucas: Pull out your last twelve months of balance sheets and calculate your working capital under different definitions. See how sensitive your purchase price is to those definitions. That exercise alone will prepare you for the negotiation table. Luna: And maybe it'll save you from being the next cautionary tale on this show. Lucas: Exactly. And speaking of saving, if these conversations have moved your work forward in some small way, a couple of dollars a month is genuinely what keeps these going — buy me a coffee dot com slash fexingo. It's a low-key way to keep the podcast ad-free. Luna: Yeah, every bit helps. And we appreciate the listeners who do that. Lucas: So next time you're reviewing a purchase agreement, don't just skim the working capital definition. Treat it like the contract it is, not a financial report. The difference can be millions. Luna: And that's the bottom line. Thanks for listening, everyone.