Beyond quality of earnings: where transaction value is really negotiated

In financial due diligence (FDD), the quality of earnings (QoE) receives most of the attention. It is the headline deliverable and often the figure around which buyers and sellers negotiate. But in a change-of-ownership transaction, the QoE is rarely the only driver of value. Net working capital (NWC), debt, and debt-like items often more heavily impact what the seller ultimately earns at closing.

When the objective is securing financing, lenders focus primarily on earnings and cash flow generation. In an acquisition, however, enterprise value is only the starting point. The amount a buyer ultimately pays, and a seller ultimately receives, is determined by purchase price adjustments to NWC, debt, and debt-like items, making these one of the transaction’s most important and heavily negotiated components. Accordingly, both buyers and sellers should carefully evaluate these areas before entering the transaction process, as they can materially influence the ultimate economics of the deal.

Enterprise value is only the starting point

Businesses are often described as selling for a multiple of EBITDA or revenue, but transactions rarely end there. Enterprise value is typically established on a debt-free, cash-free basis and then adjusted for:

• NWC delivered at closing
• Debt and debt-like items
• Other negotiated purchase price adjustments

As a result, two businesses with identical EBITDA and identical valuation multiples can produce materially different proceeds depending on how these items are defined in the purchase agreement.

A simple proceeds bridge illustrates the point:

Although the headline transaction value was $50 million, the seller ultimately received $43.75 million. Every dollar of the $6.25 million difference resulted from debt, working capital and transaction-related adjustments — not from the QoE analysis.

Sellers often prepare for EBITDA, not proceeds

This does not diminish the importance of QoE. EBITDA add-backs, such as owner compensation and run-rate adjustments, are often heavily negotiated, particularly in lower middle-market transactions. However, as diligence progresses, disagreements around EBITDA are largely resolved, while working capital targets and debt definitions often remain open and can continue to meaningfully affect transaction value.

Many sellers spend months preparing for a QoE review by cleaning up financial statements and supporting EBITDA adjustments, yet never analyze their own working capital or debt-like exposures. As a result, they enter negotiations without a position on the working capital peg or the liabilities a buyer may classify as debt.

Evaluating these issues before going to market allows sellers to negotiate from an informed position rather than reacting to buyer findings during diligence.

Definitions determine value

One of the most common and avoidable issues arises when NWC and debt definitions are drafted without sufficient input from the FDD team. While legal counsel is responsible for structuring the purchase agreement, determining whether an item belongs in NWC or debt is fundamentally an accounting question. For this reason, one of the most valuable contributions an FDD team can make is helping draft these quantifying definitions, not simply performing the QoE analysis.

Which purchase price adjustments matter most

Depending on the company’s industry and financial sophistication, significant transaction value can be gained or lost through the treatment of NWC and debt-like items on the balance sheet.

Net working capital items

• Deferred revenue: This is often the item with the most room for negotiation. The treatment of deferred revenue can follow three approaches: classifying all deferred revenue as debt, treating only the cost to service it as debt, or keeping it entirely within NWC. On one buy-side engagement, the seller proposed including all deferred revenue, including noncurrent deferred revenue, in NWC. While debt is deducted from purchase price on a dollar-for-dollar basis, NWC is evaluated against a negotiated peg. This treatment difference would have increased the buyer’s cost by several hundred thousand dollars. However, it did not reflect the obligation’s underlying economics.
• Reserve estimates: Allowances for doubtful accounts, inventory obsolescence and warranty reserves rely on management judgment. Understated reserves inflate the assets delivered at closing and can materially affect the purchase price adjustment.

Debt-like items

Obligations that do not resemble traditional debt cause many of the largest purchase price adjustments. Some appear in accrued liabilities, while others may not appear on the balance sheet at all.

Common examples include:

• Deferred compensation, earnouts and change-in-control payments: These obligations often relate to services or transactions completed before closing and are routinely negotiated as debt-like items.
• Customer credits: While treatment is often deal-specific, customer credit balances and unapplied cash may be viewed as debt-like when representing amounts ultimately refundable to customers, as the buyer assumes an obligation requiring future cash settlement without receiving incremental value.

• Accrued bonuses, PTO and commissions: Compensation earned before closing represents an obligation assumed by the buyer and is frequently treated as debt.
• Payroll and sales tax exposures: Unremitted payroll taxes or unrecorded sales tax liabilities, particularly economic nexus exposure across multiple states, can create significant debt-like obligations.
• Customer deposits: Cash received before goods or services are delivered represents an obligation to perform rather than earned revenue.
• Self-insurance and reserve liabilities: Self-funded health plans, workers’ compensation obligations and claims reserves are often understated and commonly negotiated.
• Environmental and legal obligations: Remediation costs, litigation and settlement obligations may not be recorded but can materially impact purchase price.
• Minimum operating cash: While transactions are generally structured on a cash-free basis, buyers often argue that sufficient operating cash should remain with the business. The distinction between minimum operating cash and excess cash can materially affect seller proceeds, particularly in cash-intensive businesses.

Many of these obligations carry no label identifying them as debt and may not appear on the balance sheet. Identifying them before purchase agreement finalization can significantly reduce post-closing disputes.

The NWC peg and the post-closing true-up

The NWC peg — the target level of NWC the seller must deliver at closing — is negotiated based on two primary factors:

• What is included in the NWC definition
• The historical period used to calculate the peg

A trailing twelve-month average may produce a significantly different target than a shorter measurement period, especially for seasonal or rapidly growing businesses. As a result, the selection of the measurement period is not merely an administrative exercise but a value-related negotiation that can directly affect seller proceeds.

These issues often remain unnoticed until after closing. During the true-up process, buyers and sellers compare actual NWC to the agreed-upon peg and frequently discover they interpreted the purchase agreement differently or that the peg period was not structured in their favor. Questions such as whether a liability belongs in NWC, whether a reserve is appropriate or whether an obligation should be classified as debt become disputes rather than negotiations.

Clear definitions established before signing help minimize those disagreements.

Industry considerations

The purchase price adjustments that matter most vary by industry.

• Manufacturing: Inventory seasonality, obsolete inventory and warranty reserves.
• Distribution: Purchasing cycles, vendor rebates, customer credits and returns reserves.
• Healthcare: Accounts receivable collectability, payer settlements and accrued provider compensation.
• Software and SaaS: Deferred revenue, implementation obligations and rapidly changing working capital requirements.
• Construction: Retainage, contract assets and liabilities, and job-cost estimate assumptions.
• Business services: Accrued bonuses, commissions, unbilled revenue and customer deposits.

Because these risks differ by industry, generic purchase agreement definitions often fail to capture the business’s underlying economics.

The bottom line

While QoE remains the cornerstone of FDD, it rarely solely determines transaction value. NWC, debt, and debt-like items often influence both the price a buyer pays and the proceeds a seller receives.

Organizations that involve their FDD team in drafting purchase agreement definitions — not just analyzing the financial statements — are better positioned to negotiate from an informed perspective, reduce post-closing disputes and protect transaction value.

Buyers and sellers benefit from experienced guidance in navigating financial due diligence. Sikich brings extensive expertise to both sides of the table.