Virtually every M&A deal is priced as “cash-free, debt-free,” meaning the seller keeps its cash and has to pay off funded debt. But there are two exceptions to this rule of thumb. A more obvious one that does not have much impact on the transaction, and another less obvious exception that can have a huge adverse impact for the buyer and an unearned windfall for the seller.

First the simple one. Many businesses accept some form of customer deposits or advance payments. Equipment sellers, contractors, and automobile dealers often require customers to put some money down to secure an order of product or services. In a business sale, the purchase price is reduced by the amount of the cash advanced by the customer to the extent the amount deposited has not been earned by the business seller. Thus, the cash is not free, as the seller allows the buyer to access the unearned portion of the cash which allows for the buyer to be appropriately compensated for the goods or services provided after closing. This is usually addressed in the transaction by reducing the purchase price by the amount of cash held by the seller.

Now the tricky one. Customer deposits usually represent only a portion of the amount paid for goods and services, the balance being booked as a receivable. But what happens if the customer pays everything in advance every month? That cash does not represent payment for goods or services which have already been performed and for which the seller has earned and should keep. Instead, the payment is an advance for work or goods yet to be provided which a buyer will needs after the closing since it will be providing the goods or services. We have seen this arise where the selling company provides employment services to customers as well as apparel companies which require payment in full before producing the work. If you are not careful, the seller walks away with revenue but leaves the buyer with the expense for that revenue. Ouch.

What can further shield this from discovery is that the monthly income statement shows the cash payment as fully earned revenue because the revenue is quite often fully earned on the date of the financial statements—typically the last day of the month. Since the revenue and expense end up matching by the end of the month it works out fine right up until the sale of the business.

So how do you avoid this? Good accounting and legal due diligence for one. That is, M&A professionals need to spend sufficient time to truly understand the target business. How does the money come in and how does the money go out? In this specific case, there needs to be a good conversation with the seller’s CFO or controller to confirm the timing of how and when payments are received and what expenses are matched to each payment. But primarily, the real lesson is to ensure that a rule of thumb, like “cash-free, debt-free”, does not lure you into a false sense of security.