Working Capital Traps In SMB Acquisitions
Most first-time SMB acquirers miss working capital in the deal structure. The post-close cash flow problem that follows is avoidable, and expensive.
The most common reason a well-priced SMB acquisition runs into trouble in the first ninety days is working capital. The seller knows their business has working capital. The buyer's deal lawyer mentions it during the LOI conversation. And then somehow it ends up under-discussed in the term sheet, and the buyer discovers in the first thirty days post-close that they are short on cash to operate.
What working capital actually means in this context
In an SMB acquisition, working capital is the cash, receivables, inventory, and other short-term assets the business needs to keep operating in the ordinary course, less the short-term liabilities like accounts payable and accrued expenses. The seller has been funding it for years. After close, that funding burden moves to the buyer.
If the deal structure does not explicitly handle the transfer, the buyer either pays the seller for the assets and then immediately has to fund a working capital gap themselves, or the seller takes the cash off the balance sheet at close and the buyer inherits an empty operating account on day one.
The mechanism that solves it
Sophisticated acquirers price the deal around a working capital target. The target is a normalized estimate of the working capital level the business actually needs to operate, calculated over a trailing twelve-month average. The purchase agreement specifies that the seller delivers the business with working capital at that target level, with a true-up provision that adjusts the purchase price post-close based on the actual closing balance.
If the seller delivers the business with working capital below the target, the buyer gets a cash payment equal to the shortfall. If above the target, the seller gets a cash payment for the excess. Both sides are protected, and the buyer can operate the business from day one.
The two traps I see most often
The first trap is calculating the working capital target on a trailing-twelve-month basis without looking at seasonality. A landscaping business has a different working capital profile in March than in December. A target set without seasonal adjustment will produce a true-up that benefits one side or the other based purely on the calendar.
The second trap is failing to define what counts as working capital. Is the inventory included? What about the security deposits on leased locations? Customer prepayments? Deferred revenue? Each of these decisions affects the number, and a vague definition produces post-close arguments nobody wants.
Why I always negotiate it
In my experience, the sellers who push back on a working capital provision are signaling something. Either they do not understand the standard structure, in which case it is worth taking the time to walk through it, or they are trying to extract working capital that should stay with the business.
Either way, the conversation is worth having before the term sheet, not after. Cash on hand at close is the difference between an acquirer who can run the business and one who is fighting for liquidity from week one.
Written by Ramy Stephanos, SFAdvisor - Acquire.