Why Working Capital Is the Silent Deal-Killer
Every searcher learns about EBITDA multiples. Most understand customer concentration risk and key-person dependency. But the single most common financial surprise in search fund acquisitions is working capital—the capital tied up in the day-to-day operations of the business between paying suppliers and collecting from customers.
The reason it's dangerous is simple: working capital requirements directly reduce the free cash flow available to service debt. A business that looks beautifully profitable on an EBITDA basis can be starving for cash if its working capital dynamics are poorly understood or improperly negotiated in the purchase agreement.
The Working Capital Peg: What It Is and Why It Matters
In most acquisition agreements, the buyer and seller agree on a "working capital peg"—the normalized level of net working capital (current assets minus current liabilities) that the business needs to operate. At closing, the actual working capital is measured against this peg. If it's above, the buyer pays the difference; if it's below, the purchase price is reduced.
The traps come in several forms:
Trap 1: Using the Wrong Measurement Period
Many deals calculate the working capital peg based on a trailing 12-month average. But if the business is seasonal—as many Spanish SMEs are—a simple average can misrepresent the true cash needs at the closing date. A construction company that closes most of its receivables in Q4, or an agricultural business with planting-season payables, will have radically different working capital at different times of year.
The fix: Use a 12-month average but also map the monthly fluctuations. Know exactly what the working capital position should be at your target closing date, and adjust the peg accordingly.
Trap 2: Ignoring Quality of Receivables
Not all receivables are created equal. In Spanish SMEs, it's common to find receivables aging beyond 90 days, receivables from related parties, or invoices that have been informally disputed but not written off. These "receivables" inflate the working capital number but may never convert to cash.
The fix: Age every receivable line item. Challenge any receivable over 60 days. Understand the dispute history. Adjust the peg for doubtful accounts that the seller hasn't provisioned.
Trap 3: Supplier Timing Manipulation
A seller preparing for exit may delay paying suppliers, artificially depressing current liabilities and inflating net working capital at closing. After the acquisition, those delayed payments come due immediately, creating an unexpected cash drain.
The fix: Analyze accounts payable days over the prior 24 months, not just 12. If AP days suddenly spike in the months before closing, that's a red flag that requires normalization.
Trap 4: Prepaid Revenue and Deferred Costs
Businesses with subscription or contract-based revenue may have collected cash upfront (recorded as deferred revenue) while costs are still outstanding. If the working capital peg doesn't properly account for deferred revenue as a liability, the buyer can inherit a business where they owe services to customers who have already paid the seller.
The fix: Map every deferred revenue balance to the specific service obligation it represents. Ensure these obligations are factored into both the working capital calculation and the transition plan.
Trap 5: The Cash-on-Cash-Off Discrepancy
Spanish SMEs often operate with significant cash transactions, especially in sectors like hospitality, retail, and services. The official financial statements may show one working capital picture, while the actual operational cash cycle is quite different. This isn't necessarily fraud—it's the operational reality of many smaller businesses.
The fix: Reconcile the POS system data, bank statements, and financial records independently. Understand the real cash conversion cycle, not just the reported one.
Working Capital in the Context of Deal Structure
Working capital requirements interact directly with deal structuring in ways that search fund operators need to anticipate:
- Bank covenants: Lenders often set working capital maintenance covenants. If the true working capital need is higher than what was modeled, you may breach covenants within months of closing.
- Seller notes: Many search fund acquisitions include seller financing. The seller's willingness to accept a note is partly based on their confidence that the business can service it. Working capital surprises that reduce cash flow erode this confidence and can trigger early repayment demands.
- Growth capital: The irony of working capital is that growth makes it worse. A growing business needs more working capital, not less. If you plan to grow the business post-acquisition, you need to model the incremental working capital requirement and ensure you have funding for it.
A Practical Framework
Before signing an LOI, every search fund operator should be able to answer these questions:
- What is the cash conversion cycle (DIO + DSO - DPO) for the trailing 24 months, by month?
- What is the seasonal pattern of working capital requirements?
- What percentage of receivables is aged beyond 60 days?
- Have accounts payable days changed materially in the last 6 months?
- Is there deferred revenue with outstanding service obligations?
- What is the incremental working capital requirement per unit of revenue growth?
- How does the working capital peg in the SPA compare to the closing-date actual?
"The businesses that look best on EBITDA often look worst on free cash flow. The gap, almost always, is working capital."