In our LOI, the buyer agreed to a cash-free, debt-free deal, but their draft purchase agreement classifies our accrued PTO, equipment leases, and customer deposits as debt deductions. How do we negotiate indebtedness versus working capital to avoid this price haircut?

Question

Tyler Smith · Accepted Answer

This is one of the most common backdoor valuation reductions in lower middle market M&A. Buyers routinely attempt to classify normal operating liabilities as funded indebtedness. Under a cash-free, debt-free transaction construct, every single dollar classified as indebtedness is deducted directly from your cash wire at closing, whereas items categorized as working capital are simply factored into a standard working capital target.

To protect your net sale proceeds, enforce a precise line between working capital liabilities and transaction debt during the purchase agreement drafting:

- Accrued paid time off. Argue aggressively that accrued vacation and PTO are recurring, operational liabilities required to maintain normalized business operations. They belong strictly in the working capital peg calculation, not in debt deductions, provided employee leave balances are within historical norms.
- Customer deposits and deferred revenue. Buyers claim deferred revenue represents unperformed work requiring future cash outlays without incoming revenue. Counter by showing that historical gross margins easily cover the delivery cost. Negotiate to include deferred revenue in normalized working capital, or at most, concede only the direct cost of fulfillment rather than the full gross deferred amount.
- Operating leases. Make sure operating leases for facilities and routine operational equipment remain classified as operating expenses and working capital liabilities under GAAP guidelines, rather than debt-like obligations.

Lock down these definitions explicitly in the initial LOI. Define funded indebtedness strictly as third-party borrowed money, accrued interest, bank debt, tax liens, and unpaid transaction bonuses, keeping all daily operating accruals within the working capital mechanism.