Middle-Market M&A Niche Issues: Working Capital True-Ups, Earnouts, Sandbagging, and RWI Exclusions

Circular 230 / general information notice. This article is general information only. It is not tax, legal, or accounting advice. Reading it does not create an attorney-client relationship. Tax results depend on your facts and on law that can change. Consult your own attorney and CPA before taking any action. This article was not written to be used, and cannot be used, to avoid tax penalties.

The headline price in a middle-market deal is a starting number. What the seller actually keeps depends on the working capital true-up, any earnout, the sandbagging rule, and what the buyer's R&W policy will not cover. Each of those provisions can move more money than the indemnity cap that consumed weeks of negotiation. This article goes through the drafting, the case law, and the tax treatment, with numbers.

The working capital definition

The true-up compares net working capital (NWC) at closing to a target, or "peg," and adjusts price dollar for dollar. A workable definition:

"Net Working Capital" means (a) the current assets of the Company (excluding Cash, income Tax assets, and deferred Tax assets) minus (b) the current liabilities of the Company (excluding Indebtedness, Transaction Expenses, income Tax liabilities, and deferred Tax liabilities), in each case consisting solely of the general ledger accounts and line items identified on the Illustrative Closing Statement and determined in accordance with the Accounting Principles.

"Accounting Principles" means (a) the specific policies set forth on Schedule 1.1(b), (b) to the extent not addressed by clause (a), the accounting principles, practices, methodologies, classifications, judgments, and estimation techniques used in preparing the Reference Balance Sheet, and (c) to the extent not addressed by clauses (a) or (b), GAAP consistently applied.

What each piece does:

1. The exclusions prevent double counting. Cash is usually paid to the seller separately, and debt and deal expenses reduce price under their own definitions. If accrued bonuses are a Transaction Expense, they cannot also be a current liability in NWC.

2. "Solely of the general ledger accounts" on the illustrative statement stops either side from inventing a new line item after closing.

3. The hierarchy is the most important sentence in the definition. Specific policies win, then past practice, then GAAP. Buyers sometimes want GAAP first, which lets a buyer's auditor "correct" historical reserves and convert the true-up into a claim that the old financials were wrong. Sellers should insist that consistency with the reference balance sheet controls, with GAAP only as a gap filler.

4. Specific policies worth writing down: the inventory reserve method, the bad debt reserve, accrued paid time off, and the treatment of customer deposits and deferred revenue. Deferred revenue alone can swing the true-up by a large amount in a services or software business.

The peg, the collar, and the math

Assume a $2,000,000 peg with a $50,000 collar, and the agreement adjusts only for the amount outside the collar. A final NWC of $1,970,000 is inside the band and does not move price. A final NWC of $1,850,000 is $150,000 below the peg and $100,000 below the collar floor, so the price drops $100,000.

Now add the estimate. If the seller's estimated closing statement shows $2,150,000 and there is no collar, the buyer pays $150,000 more at closing. If the final figure is $1,920,000, the seller owes back $230,000: the $150,000 overpayment plus the $80,000 shortfall from peg. A seller who received that $150,000 and distributed it to its owners now has to fund a refund. Two protections help: a separate adjustment escrow, sized to the expected swing, and a cap on how far the estimate can exceed the peg.

A buyer who thinks the peg is too low should fight about the peg before signing, using trailing monthly averages adjusted for seasonality. A buyer who discovers after closing that the peg was set off a favorable month has no claim. The peg is a price term.

Expert, not arbitrator

The dispute mechanism usually reads like this:

"Any items remaining in dispute shall be submitted to the Independent Accountant, acting as an expert and not as an arbitrator, which shall resolve only those items specifically identified in the Objection Notice, based solely on the written submissions of the parties and in accordance with the definitions in this Agreement, and whose determination of each item shall be within the range of values assigned to such item by the Buyer and the Seller. The fees of the Independent Accountant shall be allocated in inverse proportion to the relative success of each party."

Two Delaware cases explain why the words matter. In Chicago Bridge & Iron Co. N.V. v. Westinghouse Electric Co., 166 A.3d 912 (Del. 2017), the court held that a narrow true-up could not be used to assert that the seller's historical financial statements failed to comply with GAAP. Those were representation claims, and the agreement had barred them after closing. In ArchKey Intermediate Holdings Inc. v. Mona, C.A. No. 2021-0383-JTL (Del. Ch. Oct. 3, 2023), the court treated an accountant procedure as an expert determination rather than an arbitration, even though the clause used the word "arbitrator," because the accountant's authority was confined to disputed accounting items.

The practical point: limit the accountant to accounting questions, keep legal questions (what a definition means, whether a covenant was breached) for a court, and say expressly whether the Texas Arbitration Act or the Federal Arbitration Act applies, if anyone wants them to. "Inverse proportion" fee shifting rewards the party whose position the accountant adopts more often, which discourages inflated objections.

Earnouts: drafting the metric and the covenants

A representative EBITDA earnout:

"Buyer shall pay to Seller (a) $2,000,000 if Earnout EBITDA for the Measurement Period equals or exceeds $8,000,000, plus (b) an additional amount equal to $2.00 for each $1.00 by which Earnout EBITDA exceeds $8,000,000, up to a maximum aggregate Earnout Payment of $5,000,000. Earnout EBITDA shall be calculated in accordance with the Earnout Principles and shall exclude (i) any corporate overhead, management fees, or shared service charges allocated by Buyer or its Affiliates in excess of the amounts set forth on Schedule 2.6, (ii) any integration, restructuring, or severance costs, and (iii) any costs of this Agreement and the transactions contemplated hereby."

On these numbers, Earnout EBITDA of $9,000,000 pays $2,000,000 plus $2,000,000 ($1,000,000 excess x 2), or $4,000,000. Earnout EBITDA of $9,500,000 would compute to $5,000,000 and hits the cap exactly. Earnout EBITDA of $7,990,000 pays nothing. That last result is why sellers ask for a sliding scale below the threshold and buyers resist it: a single cliff makes every accounting judgment worth $2,000,000.

The exclusions are where earnout fights start. Without clause (i), a buyer can load parent-level costs into the business and erase the payment. Without clause (ii), integration choices made by the buyer reduce the seller's price.

Then the operating covenants. Buyers want an express statement that they may operate the business in their sole discretion, subject only to a promise not to act with the primary purpose of avoiding the earnout. Sellers want affirmative covenants: maintain the business as a separate unit with separate books, keep a minimum sales headcount, do not divert customers to affiliates, and accelerate the maximum payment on a sale of the business or a material breach.

The case law tracks the words. In Lazard Technology Partners, LLC v. Qinetiq North America Operations LLC, 114 A.3d 193 (Del. 2015), the agreement barred actions taken with the "intent" of reducing the earnout, and the court refused to use the implied covenant to substitute a lower standard. In the Auris litigation, Fortis Advisors LLC v. Johnson & Johnson, 2024 WL 4048060 (Del. Ch. Sept. 4, 2024), the buyer had agreed to "commercially reasonable efforts" defined by reference to its own priority products, and the Court of Chancery entered a judgment of more than $1 billion. On January 12, 2026, the Delaware Supreme Court affirmed the breach findings and damages for the remaining milestones but reversed the part of the judgment that relied on the implied covenant for the first milestone, holding there was no contractual gap to fill because the risk was foreseeable and allocated by the agreement. The lesson from both levels: courts enforce the efforts standard the parties wrote, and they will not write a better one after the fact.

Texas law makes that lesson sharper. The Supreme Court of Texas held in English v. Fischer, 660 S.W.2d 521 (Tex. 1983), that Texas does not recognize a general implied duty of good faith and fair dealing in contracts. A seller under a Texas-law earnout should assume it gets only the covenants it negotiated. If an operating covenant is not in the agreement, it is not there.

How earnouts and true-ups are taxed

A true-up or earnout that is additional purchase price changes the seller's amount realized and the buyer's basis. If any payment is received after the close of the taxable year of sale, the installment method of Section 453 can apply to installment-eligible property unless the seller elects out. Inventory and dealer property do not qualify.

For a contingent payment sale, Temp. Treas. Reg. § 15A.453-1(c) sets the basis recovery. With a stated maximum selling price, the seller computes the gross profit ratio as if the maximum will be paid. Example: $8,000,000 at closing, an earnout capped at $2,000,000, and $3,000,000 of basis in installment-eligible assets. Gross profit is $10,000,000 minus $3,000,000, or $7,000,000, and the ratio is 70%. Of the closing payment, $5,600,000 is gain and $2,400,000 is basis recovery. If an earnout payment later includes $1,000,000 of principal after interest is stripped out, $700,000 is gain. If the earnout ultimately pays less than the maximum, the regulations provide for recomputation.

Interest comes out first. If the earnout is not a debt instrument with adequate stated interest, Section 483 generally imputes interest on payments due more than six months after the sale under a contract with payments due more than one year after the sale. That interest is ordinary income to the seller, not purchase price.

For larger deals, Section 453A adds an interest charge on the deferred tax. It applies to installment obligations from dispositions of property with a sales price above $150,000 when the face amount of such obligations that arose during the year and are outstanding at year end exceeds $5,000,000. A seller with a $6,000,000 contingent earnout outstanding at December 31 should ask the CPA to model the 453A charge, because it reduces the benefit of deferral.

Finally, character. Payments that are really compensation for post-closing services are ordinary income to the seller and generally deductible by the buyer, not purchase price. An earnout forfeited if the founder leaves employment is the clearest signal of compensation treatment. Keep the earnout tied to the business's performance and pay services under a separate, market-rate employment agreement.

In an asset deal, the true-up and earnout also flow through Section 1060. An increase in consideration is allocated through the residual method, and the parties file a supplemental Form 8594 for the year it is taken into account. If Classes I through VI were already allocated at fair market value, the increase lands in Class VII goodwill and going-concern value.

Sandbagging, briefly

I cover sandbagging in more detail in reps and warranties basics. The short version: Delaware leans pro-sandbagging after Arwood v. AW Site Services, LLC, 2022 WL 705841 (Del. Ch. Mar. 9, 2022), and I do not rely on a settled Texas default. Make the choice expressly. For the true-up, add one sentence: no claim for an item may be brought both as a working capital adjustment and as an indemnity claim, so the buyer cannot recover twice for the same reserve.

What the R&W policy will not cover

A buy-side R&W policy changes who pays for most rep breaches, but its exclusions put specific risks back on the parties. Exclusions commonly addressed in underwriting include matters the deal team actually knew about before signing, purchase price adjustments, forward-looking statements and projections, certain wage-and-hour and underfunded pension matters, and items the underwriter identifies in diligence. Exclusions vary by carrier and deal, so read the binder and the specimen policy, not a summary.

Three interactions matter here. First, a policy generally will not pay for a working capital shortfall, so the adjustment escrow is the buyer's protection. Second, if the policy excludes a known tax issue, a special indemnity has to cover it. Third, the retention is a deductible the buyer bears unless the seller agrees to share it, and a seller-funded retention escrow is a negotiated term, not a default.

Where each side lands

Sellers want a definition locked to past practice with specific policies, a collar, an estimate cap and separate adjustment escrow, an accountant limited to listed items within the parties' range, an earnout with a sliding scale, overhead and integration exclusions, affirmative operating covenants, acceleration on a sale, and no offset against the earnout for disputed indemnity claims.

Buyers want GAAP to control, no collar, a clean "expert not arbitrator" clause, a single earnout threshold, broad operating discretion limited by an intent standard, and the right to set off indemnity claims against earnout payments.

A frequent middle ground: the hierarchy above with a short list of specific policies, a modest collar, a two-tier or linear earnout with overhead exclusions, operating covenants limited to keeping the business separately accounted for and not diverting customers, and set-off permitted only for finally determined claims or into escrow pending resolution.

How I can help

I negotiate purchase agreements and related middle-market documents with attention to post-closing economics, and I coordinate with the client's CPA on the accounting definitions and the tax model. Office: 1921 Greenville Avenue, Suite 200, Dallas, TX 75206. For the larger sale timeline, see what middle-market sellers should expect in a PE deal process.

FAQ

Can the buyer use the true-up to fix reserves it thinks were wrong?

Only if the definition allows it. Under a past-practice hierarchy, the accountant applies the seller's historical methods, and a claim that the historical financials were wrong is a representation claim with its own limits, as Chicago Bridge illustrates.

Is an earnout taxed when it is paid or at closing?

If installment reporting applies and the seller does not elect out, gain on installment-eligible property is generally reported as payments are received, after imputed interest is separated out. Electing out accelerates the gain to the year of sale.

Does an R&W policy cover a working capital shortfall?

Generally not. The adjustment mechanism and its escrow handle that risk, which is why the definition deserves as much attention as the policy.

Next step

For a consult on your facts, email info@robertsandwillie.com or call (469) 910-4017. Sending a message does not create an attorney-client relationship.

Disclaimer. This article is for general information only and is not tax, legal, or accounting advice. It does not create an attorney-client relationship. Tax law changes and depends on your specific facts. Do not act on this article without consulting your own attorney and CPA. This article is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or other applicable law. Attorney Advertising. Roberts & Willie, PLLC, Dallas, Texas; Trenton Roberts, responsible attorney.