Key takeaways
- The most common balance sheet issues in middle market transactions are: excess cash that needs to be defined and extracted, stale receivables that should be written off before closing, related-party balances that must be settled, and informal liabilities that are not reflected on the books.
- Excess cash is generally extracted before closing rather than included in the working capital calculation. Founders who leave excess cash in the business without a clear plan often find it trapped in the working capital peg or subject to buyer negotiation.
- Related-party receivables, loans to shareholders, and intercompany balances must be settled before closing or they become negotiating points that complicate the purchase agreement.
- A balance sheet that has not been reviewed by a CPA in the past 12 months will almost certainly have items a QoE team will reclassify. Addressing those reclassifications before banker engagement avoids EBITDA surprises mid-process.
- Contingent liabilities that are not accrued on the balance sheet, pending lawsuits, unresolved tax positions, and underfunded benefit obligations, are the balance sheet equivalent of EBITDA addbacks: buyers will price them in whether or not they are disclosed.
In this article
How to use this before a process
For adjacent context, compare this with How to build a management package buyers actually trust and How to Prepare for Management Presentations to Private Equity Buyers; the strongest operators connect these topics instead of treating them as separate workstreams.
Readiness Snapshot
What buyers will ask
What is ordinary-course working capital for this business?; Which months are distorted by seasonality, inventory, or collection timing?; How does the proposed peg change cash received at close?
What to prepare
24-month month-end working capital schedule.; Account-by-account inclusion and exclusion memo.; Seasonality, inventory, receivable, and payable normalization bridge.
12–18 months
Recommended lead time for a balance sheet review before going to market
$200K–$1.5M
Typical range of balance sheet adjustments in a middle market transaction
65%
Of middle market QoE reviews identify at least one material balance sheet reclassification
3–5 weeks
Time a balance sheet cleanup adds to a sale process when done reactively during diligence
When a buyer's QoE team reviews a company's financials, they start with the income statement, looking for EBITDA adjustments. Then they move to the balance sheet, where they are looking for two things: items that affect the working capital peg and items that represent liabilities the buyer will inherit.
The founder who has cleaned up the balance sheet before the process starts controls this conversation. The founder who has not will spend three weeks of diligence explaining stale receivables, related-party loans, and accrual gaps while the buyer builds a narrative of financial disorganization that affects their confidence in the broader business.
The seven balance sheet items to address before going to market
Seven balance sheet items to review and address before banker engagement
1. Excess cash
Cash above the operating needs of the business is typically excluded from the working capital calculation and paid out to the seller before or at closing. Identifying the normalized cash balance and creating a plan for the excess avoids mid-process disputes about what is "trapped" in the business versus available for extraction.
2. Accounts receivable aging
Stale receivables over 90 days are likely uncollectible and should be written off before closing. A QoE review will apply a reserve to any receivable over 90 days. Writing them off before going to market removes the adjustment, cleans the asset side of the balance sheet, and avoids the impression that the AR balance is overstated.
3. Related-party receivables and loans
Any receivable representing money owed to the company by the founder, a family member, or a related entity must be settled before closing or explicitly addressed in the purchase agreement. Buyers treat related-party balances as red flags that signal undisclosed transactions.
4. Inventory valuation and obsolescence
Inventory carried at cost may have a lower net realizable value if it includes slow-moving or obsolete items. A QoE team will apply an obsolescence reserve to any inventory that has not moved in 12 months or longer. Identifying and writing down obsolete inventory before closing avoids a buyer-driven adjustment.
5. Prepaid and deferred costs
Prepaid expenses that have no future economic benefit and deferred costs that should have been expensed are balance sheet inflation. A review of the prepaid and deferred accounts for items that are not recoverable economic assets avoids a reclassification adjustment.
6. Accrued liabilities
Expenses that have been incurred but not yet invoiced must be accrued. Common gaps: accrued vacation liability, accrued bonuses, accrued professional fees, and accrued warranty costs. Missing accruals understate liabilities and overstate working capital, creating a post-close adjustment when the buyer normalizes to full accrual accounting.
7. Contingent liabilities
Pending lawsuits, unresolved tax notices, warranty claims, and environmental obligations that are not reflected on the balance sheet are liabilities the buyer will discover in diligence. Buyers who discover undisclosed contingent liabilities increase their indemnification escrow and reduce their confidence in the seller's representations.
The single most impactful balance sheet preparation step is an AR aging review. In most middle market businesses, 8 to 15 percent of the gross AR balance is over 90 days. Writing those balances off before going to market removes a predictable QoE adjustment and cleans the working capital baseline.
Excess cash: how to define it and extract it
In most middle market transactions, the purchase price assumes the business is delivered with a "normal" level of cash, the amount needed to fund ongoing operations. Cash above that level is considered excess and is either paid out to the seller before closing or added to the purchase price as a closing adjustment.
The challenge is defining what "normal" operating cash is. Different buyers will have different views, and an undefined cash position at the start of the process creates a negotiating dispute that could have been avoided.
How to determine normalized operating cash
Method 1: Days of operating expense coverage
Calculate the average daily operating expense (annual operating expenses divided by 365) and multiply by 30 to 45 days. This is the cash required to cover one month to six weeks of operations without any new revenue. Cash above this level is excess.
Method 2: Historical low-point analysis
Review the cash balance at its lowest point in each of the last 12 months. The lowest point across 12 months represents the minimum operating cash required. Cash above this level at any given month end is excess.
Method 3: Banker and advisor consensus
Present both methods to the banker before going to market. The number that becomes the working capital cash component should be agreed with the banker before the first buyer receives a CIM.
Once the normalized cash balance is defined, excess cash is extracted through a distribution, a dividend, or a shareholder loan repayment before the sale process begins. Excess cash that is left in the business at closing is subject to the working capital peg calculation and may be partially captured by the buyer depending on how the peg is set.
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Run an AI readiness scan →Addressing related-party balances
Related-party transactions are one of the most common sources of QoE adjustment and diligence friction in founder-owned businesses. They include: loans from the company to the founder or family members, loans from the founder to the company, management fees paid to a related entity, rent paid to a founder-owned property, and transactions between the company and other businesses the founder controls.
None of these are inherently problematic, but all of them must be either settled before closing or explicitly disclosed and normalized in the financial statements. Buyers who discover undisclosed related-party transactions mid-diligence treat them as a controls failure regardless of the economic reality behind the transaction.
Contingent liabilities: how to document and disclose informal obligations
Contingent liabilities are obligations that exist but are not formally recorded on the balance sheet because they depend on a future event, a lawsuit outcome, a tax audit result, a warranty claim, or an environmental remediation obligation. In founder-owned businesses, there is often a second category: informal obligations that exist in practice but have never been formalized. A handshake deal to pay a departing employee a severance amount not documented anywhere. A vendor whose contract was never terminated but who has been paid informally. A lease on a property the company vacated but never formally surrendered. These informal obligations are not technically contingent liabilities, they are liabilities. They just have not been recognized.
Buyers and their counsel will find informal liabilities during diligence even when the seller does not disclose them. A vendor who receives a 1099 for informal payments. A former employee whose departure was documented in email. A lease listed in the secretary of state records. The founder who does not disclose these before the process starts loses the ability to frame them favorably. The one who discloses proactively controls the narrative.
The practical step before going to market is a contingent liability review with outside counsel. Counsel will walk through the company's litigation history, tax position, environmental exposure, regulatory status, and any informal obligations the founder identifies. The output is a liability schedule that can be presented to the banker before going to market, allowing the banker to incorporate known contingencies into the deal structure from the start rather than having them surface as surprises during diligence.
The balance sheet review timeline
A balance sheet review done 12 to 18 months before going to market allows time to address findings without time pressure. The same review done during diligence is done under a buyer's scrutiny, with every finding becoming a price negotiation.
Balance sheet preparation timeline
18 months before process
Engage CPA or advisor for a pre-transaction balance sheet review. Identify all related-party balances, contingent liabilities, stale AR, and accrual gaps. Build a remediation plan.
12 months before process
Execute remediation: write off uncollectible AR; settle related-party balances; accrue missing liabilities; address inventory obsolescence.
6 months before process
Confirm remediation is complete and reflected in the monthly financials. Ensure the last six months of management-prepared statements reflect the clean balance sheet.
Banker engagement
Provide the banker with a balance sheet summary that identifies the normalized cash balance, confirms related-party balances are settled, and flags any remaining contingent liabilities. This prevents the banker from being surprised by items the QoE team will find.
A $19M services company went to market without a pre-transaction balance sheet review.
The buyer's QoE team found: $380K of AR over 90 days with no reserve; a $220K loan from the company to the founder's other business, recorded as a receivable; $145K of accrued vacation liability that had not been recorded for two years; and $85K of prepaid software licenses for systems that had been retired. Total balance sheet adjustment: $830K.
At 7x EBITDA, the purchase price impact of the working capital and liability adjustments was approximately $1.1M. The founder's attorney estimated that a $15K pre-transaction balance sheet review 12 months earlier would have identified and resolved all four items.
Frequently asked questions
What should a founder do first?
Identify the specific buyer concern this topic creates and assemble the documents that prove the answer. The goal is to make the diligence response evidence-based before a buyer asks the question.
Why does this matter in a sale process?
Because buyers convert uncertainty into price, structure, or diligence friction. A documented answer reduces the perceived risk and keeps the discussion focused on value rather than cleanup.
What is the most common mistake?
Waiting until after LOI exclusivity to fix the issue. At that point the buyer has leverage, the timeline is compressed, and every gap is interpreted through a risk-adjustment lens.
Work with Glacier Lake Partners
Review Your Balance Sheet Before Going to Market
We help founders identify and resolve balance sheet issues before banker engagement.
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Disclaimer: Financial figures and case-study details in this article are anonymized, composite, or representative examples based on middle market operating situations, and are not guarantees of outcome. Statistical references are drawn from cited third-party research; individual transaction and operational results vary based on business characteristics, market conditions, and deal structure. This content is for informational purposes only and does not constitute legal, financial, or investment advice. Consult qualified advisors for guidance specific to your situation.
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