The buy-side Quality of Earnings team is auditing our financials and trying to capitalize our ongoing software development labor to make our historical EBITDA look higher, but we know this will lead to a massive working capital adjustment that hurts us at closing. How do we fight this treatment?

Question

Tyler Smith · Accepted Answer

It is common for buy-side Quality of Earnings analysts to use aggressive accounting treatments that seem beneficial on the surface but carry hidden penalties. By capitalizing your internal software development labor, they artificially inflate your historical EBITDA, which raises the headline enterprise value. However, this capitalization also converts normal operating cash outflows into capital expenditures, which dramatically inflates your required net working capital peg.

To fight this, you must present a clear, documented policy of how your software development team actually spends their time. Use your weekly Scorecard history and quarterly Rock tracking to prove that your software engineers are focused on routine maintenance, bug fixes, and operational updates, which GAAP dictates must be expensed as incurred.

Only true, net-new feature development can legally be capitalized. If your team spends eighty percent of their time maintaining the current system to support client delivery, those costs are operating expenses.

By proving this operational reality, you keep those labor costs expensed. This lowers your adjusted EBITDA slightly but protects you from a massive, dollar-for-dollar working capital adjustment at close that would force you to leave a huge amount of cash in the business. Your goal is to maximize the cash you actually pocket at closing, not just the headline number on a letter of intent.