When buyers conduct due diligence on a Canadian business acquisition, most of the attention goes to the obvious financial metrics — revenue, EBITDA, gross margins, and the balance sheet. Deferred revenue, work in progress, and inventory don't always get the same scrutiny. That's a mistake that can be expensive to discover after closing.
If you're buying a business in Canada — whether you're a Canadian buyer or an American buyer acquiring a Canadian company — understanding how these three items affect the purchase price, the working capital calculation, and your post-closing financial position is one of the most important parts of due diligence. Getting it wrong doesn't just affect the numbers. It affects whether the deal you thought you were buying is the deal you actually got.
Deferred revenue is money that a business has already collected from its customers but has not yet earned — because the product hasn't been delivered or the service hasn't been performed yet. It sits on the balance sheet as a liability, not as income, because the business still owes the customer something in exchange for that payment.
Common examples of deferred revenue in small and mid-sized Canadian businesses include:
Customer deposits — payments collected upfront before a product is manufactured, ordered, or delivered. Common in manufacturing businesses, custom fabrication, equipment businesses, and construction-related companies.
Customer prepayments — advance payments for services that will be delivered over a future period. Common in software businesses, subscription-based businesses, service companies, and maintenance contract businesses.
Gift cards and store credits — obligations to provide future goods or services to retail customers who have already paid.
Annual service contracts paid upfront — where a customer pays for a full year of service at the beginning of the contract period and the service is delivered monthly over the year.
Retainers and advance fees — amounts collected in advance for professional services not yet rendered.In each of these cases, the business received the cash — but it hasn't earned it yet. When you buy that business, you are acquiring the obligation to deliver on those commitments. That obligation has a real cost.
This is the point that catches buyers off guard most frequently. Deferred revenue looks like cash in the bank — the business collected it, it's sitting in the account, and it shows up in the financial statements. But it is not the seller's money to keep. It belongs, in effect, to the customer, who is owed a product or service in return.
When a buyer acquires a business with significant deferred revenue and doesn't adjust the purchase price to account for it, the buyer is paying for cash that they will immediately have to spend fulfilling the seller's outstanding obligations. That is not a neutral outcome. It is a wealth transfer from the buyer to the seller that was built into the deal structure — and it happens silently if due diligence doesn't catch it.
If a business has $500,000 in customer deposits on its balance sheet at closing, the buyer is acquiring $500,000 in future obligations — goods or services that must be delivered to customers who have already paid. If that obligation isn't properly reflected in the purchase price adjustment or the working capital peg, the buyer has effectively overpaid by the cost of fulfilling those obligations.
Work in progress — sometimes called WIP — refers to jobs, contracts, or projects that have been started but not yet completed at the time of the acquisition. It is most common in businesses that perform project-based work, including construction companies, engineering firms, manufacturing businesses, custom fabrication shops, technology companies delivering implementation projects, and professional services firms.
Inventory is a closely related issue — raw materials, partially completed goods, and finished products sitting on the shelf or in the warehouse at the time of closing.
Both of these items share the same fundamental problem in a Canadian business acquisition — and it is a problem that catches buyers and sellers off guard more often than almost any other issue in a deal.
Here is what actually happens in the vast majority of small and mid-sized Canadian business acquisitions where work in progress and inventory aren't specifically addressed in the letter of intent:
The buyer assumes WIP and inventory are included in the purchase price. From the buyer's perspective, they are buying the business — and the business includes everything in it. The partially completed jobs, the raw materials, the finished goods sitting in the warehouse — all of it is part of what they are paying for. That assumption feels logical and it feels obvious. The buyer doesn't raise it because they assumes it's settled.
The seller assumes the opposite. From the seller's perspective, the purchase price was negotiated based on the earning power of the business — typically a multiple of EBITDA or revenue. The WIP and inventory represent additional value that sits on top of that earning power. The seller either expects to be paid separately for it on top of the purchase price — or expects to be allowed to keep it, finish the work themselves, and collect the revenue before handing over the keys.
Both of these assumptions feel completely reasonable to the person holding them. Neither party is being unreasonable or dishonest. They are simply starting from different places — and if nobody addresses it explicitly in the letter of intent, those two assumptions will collide somewhere between signing and closing, usually at the worst possible moment in the negotiation.
The result is a dispute that is disproportionately damaging to the deal relative to its dollar value — because it surfaces late, it feels like a surprise to both sides, and it tends to create distrust at exactly the stage of the transaction when both parties need to be working together to get to close.
The letter of intent is not just a price and structure document. It is the document that establishes the shared assumptions of the deal — what is included in the purchase price and what isn't. Work in progress and inventory need to be explicitly addressed at the LOI stage for one simple reason: it is significantly easier to have that conversation before both parties have committed to the deal than after the purchase agreement is being negotiated and everyone is tired, under pressure, and looking for reasons to protect their position.
A well-drafted LOI should answer the following questions clearly:
Is work in progress included in the purchase price — and if so, on what basis? If the purchase price includes WIP, how will the value of that WIP be calculated and verified? Who bears the risk of cost overruns or incomplete projects?
Is inventory included in the purchase price — and if so, at what value? Will inventory be counted and verified at closing? How will obsolete, slow-moving, or damaged inventory be treated?
If WIP and inventory are not included in the purchase price, how will they be valued and paid for separately? Will there be a separate purchase price adjustment mechanism? Will the seller be permitted to complete open jobs and retain the revenue before closing?
None of these questions have a universally correct answer. The right outcome depends on the nature of the business, the size and composition of the WIP and inventory, and the negotiating positions of both parties. But the questions must be answered — in writing, in the LOI — before the purchase agreement is drafted. Leaving them for later is not neutral. It is a guarantee of a dispute.
When WIP and inventory assumptions aren't resolved before closing, they don't disappear. They resurface — usually in the form of a post-closing dispute between buyer and seller over who is owed what.
The buyer closes on the business expecting the WIP and inventory to be there. The seller, operating on a different assumption, has either completed the open jobs and kept the revenue, drawn down the inventory, or is expecting a separate payment that the buyer has no intention of making.
Post-closing disputes over WIP and inventory are among the most common and most avoidable sources of conflict in small business acquisitions in Canada. They are avoidable not because the issue is legally complicated — it isn't — but because they are almost always the product of two parties who never had an explicit conversation about it and assumed the other side saw things the same way.
The time to identify and quantify deferred revenue, work in progress, and inventory is at the very beginning of due diligence — not at the end of it and not during purchase agreement negotiations. As part of your initial due diligence request list, ask the seller for:
A complete deferred revenue schedule broken down by customer, contract, amount received, and estimated delivery or completion date. This tells you the size and nature of the obligation you are acquiring and allows you to assess whether the purchase price properly accounts for it.
A work in progress schedule showing every open contract — the original contract value, costs incurred to date, estimated costs to complete, estimated completion date, and current project status. This project-level detail is the only way to assess the true financial position of the WIP and identify any projects that are running over budget, behind schedule, or at risk of customer disputes.
A full inventory count or valuation, including the age and condition of the inventory and any items that are obsolete, slow-moving, or damaged.
Once you have a preliminary picture of the deferred revenue, WIP, and inventory position, those items need to be addressed explicitly in the letter of intent before you sign it. This is the single most important practical step a buyer can take to avoid the assumption gap described above.
A buyer who signs an LOI without addressing WIP and inventory has implicitly accepted ambiguity on two of the most common sources of post-closing disputes in Canadian business acquisitions. A buyer who addresses them explicitly in the LOI — even if the final outcome is still to be negotiated — has established a framework for resolving them before the purchase agreement negotiations begin.
If due diligence reveals that the business carries significant deferred revenue obligations, loss-making or incomplete WIP, or inventory that is overstated in value, the buyer has a legitimate basis to seek a purchase price reduction or adjustment. This is a normal and appropriate part of the negotiation process in a Canadian business acquisition — but it only works if the issue is identified early enough to be part of the negotiation rather than a post-closing surprise.
These issues don't affect every Canadian business acquisition equally. The industries where deferred revenue, work in progress, and inventory are most likely to be material issues include:
Manufacturing businesses — customer deposits on custom orders, significant raw material and finished goods inventory, and open production runs all create deferred revenue and WIP exposure that must be addressed in the LOI and purchase agreement.
Construction and engineering companies — project-based businesses with multiple open contracts at any given time are among the highest-risk environments for WIP disputes in Canadian business acquisitions.
Software and technology businesses — annual subscription contracts paid upfront generate significant deferred revenue that sits on the balance sheet as a liability. SaaS businesses and software companies with recurring revenue models almost always carry material deferred revenue.
E-commerce businesses — customer orders placed and paid for but not yet shipped represent deferred revenue. Inventory levels and the mix of fast-moving versus slow-moving or obsolete inventory can significantly affect the true value of the business.
Franchise businesses — franchise fees paid by franchisees in advance and gift card obligations are common sources of deferred revenue in franchise acquisitions in Canada.
Auto repair and automotive service businesses — customer deposits on parts orders and vehicles in for repair that haven't been completed at closing create WIP exposure.
Heavy equipment and transportation businesses — parts inventory, equipment under repair, and service contracts with prepaid components all create deferred revenue and WIP considerations.
Professional services firms — retainers, advance fees, and open client matters create both deferred revenue and WIP exposure that must be quantified and addressed in the acquisition documents.
Consumer products businesses — finished goods inventory valuation and obsolescence risk are material considerations in any consumer products acquisition.
At Tetrapolar Law, I work exclusively for buyers acquiring businesses in Canada — Canadians and Americans buying small and mid-sized Canadian businesses typically in the $1 million to $25 million range across a wide range of industries including manufacturing, software, e-commerce, professional services, franchises, transportation, heavy equipment, auto repair, and consumer products.
Deferred revenue, work in progress, and inventory issues come up regularly in acquisitions across all of these sectors. Identifying them early, addressing them explicitly in the letter of intent, structuring the purchase agreement to protect the buyer, and negotiating appropriate price adjustments where warranted is a core part of what buyer-side M&A legal counsel does — and it is exactly the kind of issue where getting experienced legal advice before you sign a letter of intent pays for itself many times over.
If you're buying a business in Canada and you want to make sure your due diligence and your LOI cover the issues that actually matter — including deferred revenue, work in progress, inventory, and the other financial and legal risks that are easy to miss — I'd like to help.
The one-hour deal strategy session is a good starting point if you're not ready to retain legal counsel yet. No retainer, no commitment. Just an honest conversation about where you are and what you're walking into.
Come as you are. You don't need to have it all figured out yet.
Stefan McConnell is the founder of Tetrapolar Law, a Canadian M&A law firm focused exclusively on buyer-side business acquisitions in Canada. He is a former Partner at a national Big Law firm with 18+ years of M&A experience and the author of Unlock Your Future: A Guide to Buying a Business for Maximum Profit and Freedom. He advises both Canadian and American buyers on business acquisitions across Canada.
Contact: info@tetrapolar.ca | www.tetrapolar.ca