Brightwater HVAC Distribution: December Spike, Seasonal Peg and the Three Findings That Matter

Deliverable 1: Deal Partner Memo

MEMORANDUM

TO: Dana Whitfield, Deal Partner FROM: Private Equity Financial Due Diligence Team DATE: January 18, 2025 SUBJECT: Brightwater Supply Co. — Key Findings, Valuation Adjustments & Working Capital Peg

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Executive Summary: The Three Findings That Change Price or Structure

Brightwater’s reported $7.7M Adjusted EBITDA and proposed $11.6M flat Net Working Capital (NWC) peg overstate normalized earnings power and expose Kestrel Ridge to a multi-million-dollar post-closing cash drain. We recommend an immediate purchase price adjustment of $2.29M to $2.84M (via EBITDA multiple reduction and debt-like items) and replacing the seller’s proposed $11.6M peg with a June-specific seasonal peg of $15.3M, preventing an unjustified $3.7M closing cash payout to the seller.

``` ======================================================================================== Summary of Key Valuation & Structuring Impacts ========================================================================================

1. December Cutoff EBITDA Adjustment: -$1.58M to -$1.98M EV reduction (at 7.01x)
2. Debt-Like Balance Sheet Deductions: -$0.71M to -$0.86M Dollar-for-dollar

------------------------------------------------------------------------------------- Total Recommended Enterprise/Equity Cut: -$2.29M to -$2.84M Purchase Price Reduction

3. Seasonal NWC Peg Adjustment: Prevents a $3.7M Cash Transfer at Close

======================================================================================== ```

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Finding 1: December Revenue Cutoff Acceleration ($0.98M to $1.23M shifted; -$1.58M to -$1.98M EV impact)

• The Issue: December revenue rose 22% sequentially ($6.1M vs. $5.0M in November), reversing historical seasonality (typically flat to -3%). Testing 80% of December invoices >$15K ($1.12M total) revealed 29 invoices totaling $0.98M with blank or "will-call/hold" ship-to lines that did not ship until January 6–14 per carrier bills of lading. Inventory was not physically relieved in December (units were down only 0.8% MoM). In the first week of January, management issued $310K of credit memos for "date changes." Marisol Reyes (Senior Accountant) confirmed the December GL was held open for three extra days at the CFO’s instruction.
• Valuation Impact: At a 27% gross margin less 4% variable selling costs (23% flow-through), the $0.98M tested revenue overstatement inflates December EBITDA by $225.4K. Extrapolated across 100% of the population, the overstatement is ~$1.225M in revenue, or $281.8K in EBITDA. At the 7.01x entry multiple ($54.0M EV / $7.7M EBITDA):
• Tested base EV adjustment: -$1.58M
• Extrapolated EV adjustment: -$1.98M
• Collateral Implications: Reversing $0.98M drops full-year revenue to $70.42M, missing the management bonus threshold ($71.0M). Additionally, normalized EBITDA breaches Fifth Ohio Bank’s 1.20x Fixed Charge Coverage Ratio covenant (reported at 1.22x on unadjusted figures), creating bank financing and consent risk.

Finding 2: Unhedged Closing Working Capital Peg ($3.7M Cash Exposure)

• The Issue: The banker proposed an $11.6M flat peg, marketing it as the TTM average. The true unadjusted 12-month average is $12.0M (the banker selectively excluded peak summer months). More importantly, the transaction closes June 30, Brightwater’s peak seasonal ramp.
• Structuring Impact: Over the past three years, June NWC has consistently run between $12.6M and $14.9M (averaging $15.3M projected for the current run-rate). If Kestrel Ridge accepts an $11.6M flat peg for a June 30 close, actual closing NWC will settle at ~$15.3M. Under standard closing mechanics:

$$\text{Upward Cash Adjustment to Seller} = \$15.3\text{M} - \$11.6\text{M} = \mathbf{\$3.7\text{M}}$$ This creates an unintended, unfinanced cash gift to the seller at closing. The peg must be matched specifically to June seasonal requirements.

Finding 3: Inadequate AR Valuation Allowance & Unreconciled Subledger ($0.71M to $0.86M Dollar-for-Dollar Deduction)

• The Issue: DSO has deteriorated from 41 to 54 days over 24 months, with $2.06M (21%) of AR past due and $882K >60 days past due. Brightwater carries an allowance of only $150K (1.5% of AR).

1. *Delmar Mechanical Dispute:* $1.1M account balance, with 70% ($770K) >60 days past due. Reyes confirmed an unresolved pricing dispute has been discussed for months, with credit memos agreed to conceptually but withheld from the books.
2. *Unreconciled AR Variance:* The AR subledger has had an unexplained $210K credit/plug discrepancy against the general ledger since September.

• Structuring Impact: We recommend taking a dollar-for-dollar debt-like reduction to equity value of $710K to $860K at closing:
• Delmar Reserve: $500K–$650K (contingent on definitive dispute settlement docs).
• Subledger Variance Write-off: $210K.

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Appendix: Secondary Due Diligence Observations & Next Steps

1. Seller QoE Reliance: The buy-side cannot rely on the seller QoE report (“no revenue recognition concerns noted”). It was prepared for the vendor, failed to audit shipping documentation against invoice dates, and overlooked obvious monthly cutoff lags.
2. Post-Closing Inventory True-Up: Because December sales were improperly billed while inventory remained on hand, the opening inventory balance at January 1 is misstated. Physical inventory counts must be tied back to cutoffs to prevent gross margin distortion in Q1.
3. Covenant Default & Third-Party Consents: Fifth Ohio Bank will discover the covenant violation upon receipt of audited financials. We must require the seller to deliver either an executed covenant waiver or a fully documented refinancing package prior to signing.
4. Closing Indemnity for Delmar: Demand a specific dollar-for-dollar seller escrow ($1.1M) or indemnity covering all pre-closing commercial and pricing disputes with Delmar Mechanical.

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Deliverable 2: Proposed Net Working Capital Peg

1. Recommended Peg Structure & Methodology We reject the seller’s proposed $11.6M flat peg. We propose a Transaction-Date Specific Peg of $15.3M for a June 30 close (or alternatively, a contractually binding Monthly Peg Schedule if closing slips).

``` ======================================================================================== Historical Net Working Capital Trend ($M) ======================================================================================== Month Year -2 Year -1 Last Year 3-Yr Average Current Normalized* ---------------------------------------------------------------------------------------- January $8.9 $9.4 $10.0 $9.43 $10.5 February $8.7 $9.2 $9.8 $9.23 $10.3 March $9.4 $10.0 $10.7 $10.03 $11.2 April $10.2 $11.0 $11.8 $11.00 $12.4 May $11.4 $12.3 $13.2 $12.30 $13.9 June $12.6 $13.7 $14.9 $13.73 $15.3 <-- CLOSING July $13.3 $14.4 $15.5 $14.40 $16.0 August $12.9 $13.9 $14.8 $13.87 $15.4 September $11.3 $12.1 $12.9 $12.10 $13.5 October $9.8 $10.4 $11.0 $10.40 $11.6 November $9.2 $9.7 $10.2 $9.70 $10.7 December $9.0 $9.6 $10.4 $9.67 $10.8 ---------------------------------------------------------------------------------------- TTM Average $10.56 $11.31 $12.10 $11.32 $12.63 ======================================================================================== *Normalized for compound annual revenue growth of ~7.0% per year and adjusted for cutoff clean-up. ```

2. Detailed Method Justification

1. Neutralizing the Seasonal Arbitrage: HVAC distribution working capital is intensely seasonal, driven by commercial contractor purchasing in late spring and summer. Working capital expands by ~50% from the February trough ($9.8M) to the July peak ($15.5M). Because the purchase agreement stipulates a June 30 closing, closing NWC reflects peak seasonal receivables and inventory. Imposing an annual average peg (12-month) on a seasonal peak closing date artificially manufactures a cash deficit for the buyer, requiring Kestrel Ridge to pay the seller an unearned $3.7M purchase price premium.
2. Accounting for 7% Underlying Top-Line Growth: Brightwater’s NWC expands at ~7% annually alongside sales. Last year’s actual June balance was $14.9M. Applying normalized 7% growth projects June NWC at $15.9M. Backing out the normalized impact of delinquent AR adjustments and unbilled inventory adjustments yields a clean $15.3M June peg.
3. Execution Mechanism: The purchase agreement should state:

• *Target Working Capital:* $15.30M (assuming closing between June 15 and July 15).
• *Closing Adjustment:* If closing occurs in a different month, the peg automatically resets based on the monthly schedule above (e.g., July = $16.0M, August = $15.4M).

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Deliverable 3: Talking Points Script — Revenue Timing & Cutoff Discussion

Meeting: Due Diligence Review — Brightwater Supply Co. Attendees: Kestrel Ridge Deal Team, Brightwater CFO, Tolliver & Marsh (Sell-side Banker) Tone: Objective, evidence-based, collaborative, and non-accusatory. *Focus strictly on audit evidence, GAAP revenue recognition, and closing balance sheet integrity.*

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1. Context & Collaborative Framing > "Thanks for taking the time to walk through the monthly operating bridge. Our goal today is to align on the standard accounting cutoff mechanics so we can finalize our valuation bridge and debt financing package with Fifth Ohio. We want to ensure our closing balance sheet is clean and withstands post-closing audit scrutiny without restatement."

2. Stating the Facts (What the Evidence Shows) > "In reviewing the December sales performance, we noticed December revenue jumped 22% sequentially over November to $6.1M, which diverges from historical trends where December is generally flat to down a few points. > > To understand that cadence, our team sampled 34 invoices issued between December 26 and December 31, representing $1.12M in gross billing. Here is what the logistics and shipping records show: > * Five of those shipments, totaling roughly $140K, shipped on December 29th and 30th with valid freight receipts. Those are completely legitimate December sales. > * However, for 29 invoices totaling $980K, the carrier bills of lading and pickup timestamps clearly show the goods physically left the Columbus warehouse between January 6th and January 14th. On the December sales ledger, these were marked as 'will-call' or had the ship dates left blank. > * We also noted a credit memo batch totaling $310K entered during the first week of January tagged as 'customer requested date changes,' alongside physical inventory on hand that remained virtually flat from November to December."

3. What We Can and Cannot Conclude > "We want to be very precise about what we can and cannot conclude from this data: > * What we can conclude: Under GAAP (ASC 606), control and title of these goods did not transfer to the customer on or before December 31. Therefore, this $980K of revenue belongs in January, not December. > * What we cannot conclude: We are not making any assumptions about intent, process breakdowns, or why warehouse staging differed from the billing schedule. That is an internal operational matter. But from a financial due diligence and valuation perspective, the revenue recognition boundary is unambiguous."

4. The Path to Resolution > "Because this revenue will be recognized in the current fiscal year (which Kestrel Ridge will own post-close), it needs to be shifted into January for valuation and quality-of-earnings purposes. > > Here is what we need to agree on to maintain our transaction timetable: > 1. EBITDA Normalization: We will adjust December EBITDA down by approximately $225K to reflect the gross margin less variable costs on that $980K of delayed shipments, and we will update our valuation model accordingly. > 2. Audit & Lender Alignment: Because this cutoff adjustment moves reported FY revenue below the bank covenant testing threshold of 1.20x FCCR, we should work together with Fifth Ohio Bank now to obtain an advance waiver so closing financing is fully protected. > 3. Subledger Cleansing: We will net out the corresponding AR and inventory positions so that closing working capital reflects true delivered orders. > > Let's look at the supporting invoice log together now and ensure our teams are aligned on the numbers."

(1) Memo to Dana Whitfield — Brightwater HVAC Distribution QoE / NWC Issues

To: Dana Whitfield, Kestrel Ridge Partners From: Lead FDD Associate Re: Brightwater — three findings that change price or structure Date: Current

Executive takeaways — three findings that matter

| # | Finding | Dollar impact / recommended action | |---|---|---| | 1 | December revenue timing issue: $0.98M of sampled December invoices appear to have shipped in January. In the Dec. 26–31 sample, 29 of 34 invoices totaling $0.98M had bills of lading / carrier pickup dates from Jan. 6–14, while the invoices had blank ship-to dates or “will call/hold.” Only $0.14M appears legitimately shipped Dec. 29–30. Books were also held open “about three extra days.” | If these sales should be recognized in January, FY revenue is overstated by $0.98M and EBITDA is overstated by approx. $0.225M: $0.98M × 27% gross margin less 4% variable selling cost. At the seller’s implied 7.0x multiple, that is ~$1.6M of enterprise value. This would also reduce reported FY revenue from $71.4M to ~$70.4M, below the $71.0M bonus trigger. We cannot conclude intent, but the evidence contradicts “no revenue recognition concerns noted.” Require an EBITDA adjustment, expanded cut-off testing, and rep / indemnity around revenue cut-off and bonuses. | | 2 | NWC peg proposed by seller is structurally wrong for a June 30 close. Seller proposes $11.6M, based on a trailing 12-month average that also appears to exclude two months. Actual last-year monthly NWC averages ~$12.1M, not $11.6M. More importantly, Brightwater is highly seasonal: June/July/August NWC runs ~$14.8M–$15.5M last year versus ~$10M–$11M in winter months. | For a June 30 close, peg should be a month-specific June peg, not an annual average. Using last June NWC of $14.9M grown by the stated ~7% annual growth gives a proposed June peg of ~$15.9M. Versus seller’s $11.6M, the structure could create a ~$4.3M purchase price overpayment / true-up leakage if normal June working capital is delivered but treated as “excess.” Recommend month-by-month peg schedule tied to close month. | | 3 | AR collectability and reconciliation risk is under-reserved. Total AR at Dec. 31 is $9.8M; 9% / ~$0.88M is over 60 days past due. Largest customer Delmar Mechanical is $1.1M, with 70% / ~$0.77M over 60 days and subject to a pricing dispute. Bad debt reserve is only $0.15M. Staff accountant also noted the AR subledger has not tied to GL by ~$0.21M since September. | Minimum specific exposure is ~$0.62M incremental reserve if the $0.77M Delmar over-60 balance requires reserve against the existing $0.15M reserve; plus $0.21M unresolved AR reconciliation exposure. Recommend $0.8M–$1.0M AR-specific escrow or closing NWC reserve adjustment, pending cash collections, Delmar resolution, and AR subledger tie-out. This is a dollar-for-dollar purchase price / NWC issue, not a multiple issue unless bad debt expense has been normalized in EBITDA. |

What we can and cannot conclude

We can conclude:

• A material portion of late-December invoicing has documentary shipping evidence in January, not December.
• Seller’s proposed NWC peg does not reflect June seasonality and appears understated versus the full 12-month average.
• AR reserve coverage is light relative to known aging, Delmar dispute status, and the unresolved AR subledger / GL difference.

We cannot conclude from current evidence:

• That management intended to manipulate revenue, bonuses, or lender covenant compliance.
• That all $0.98M is definitively improper without reviewing customer terms, bill-and-hold support, title transfer, customer acceptance, and any customer-requested delayed delivery documentation.
• The exact FCCR covenant impact because fixed charges and lender calculation details were not provided.
• The precise Delmar loss amount until we see the dispute correspondence, subsequent cash receipts, credits, and legal / commercial assessment.

Appendix — other diligence items to run down

• December revenue was up 22% over November, while historical December is normally flat to down 3% versus November.
• Reported FY revenue was $71.4M, just above the $71.0M CEO/CFO bonus pool trigger. Need bonus pool amount and accounting treatment.
• December FCCR was reported at 1.22x versus 1.20x minimum; revenue timing adjustment could matter, but cannot size without lender model.
• January credit memo / reversal batch of $0.31M for “customer requested date changes” should be traced to original December invoices; could overlap with the $0.98M sample and should not be double-counted without tracing.
• Inventory units on hand were essentially unchanged from November to December, which is directionally inconsistent with a large late-December sell-through.
• Seller QoE was seller-engaged and states “no revenue recognition concerns noted”; we should perform our own expanded cut-off testing.
• AR subledger / GL has been out of balance by ~$210K since September; require reconciliation before close.
• Delmar credit has been discussed but not booked; require written support and subsequent cash receipt testing.
• Purchase agreement should include robust closing NWC definitions, specific AR reserve treatment, revenue cut-off rep, no undisclosed covenant default rep, and access to January–June monthly results before close.

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(2) Proposed NWC Peg

Recommendation

Use a month-specific peg schedule, with a June 30 peg of $15.9M.

I would not accept the seller’s $11.6M trailing average peg for a June 30 close because the business is seasonal and June is a peak working capital month. HVAC distribution builds AR and inventory through the summer selling season. A simple annual average would understate the normal working capital required at closing and could require Kestrel to pay extra for normal seasonal working capital.

Proposed peg schedule

Method: use most recent year monthly NWC, grown by the stated ~7% annual business growth rate. If closing remains June 30, use June. If closing moves, use the applicable month.

| Close month | Last year NWC | Proposed peg, grown 7% | |---|---:|---:| | Jan | $10.0M | $10.7M | | Feb | $9.8M | $10.5M | | Mar | $10.7M | $11.4M | | Apr | $11.8M | $12.6M | | May | $13.2M | $14.1M | | Jun | $14.9M | $15.9M | | Jul | $15.5M | $16.6M | | Aug | $14.8M | $15.8M | | Sep | $12.9M | $13.8M | | Oct | $11.0M | $11.8M | | Nov | $10.2M | $10.9M | | Dec | $10.4M | $11.1M |

Why this method

• Matches seasonality to closing date. A June close should be benchmarked to normal June working capital, not average annual working capital.
• Uses the most recent operating year. Brightwater has grown about 7% per year, so older periods understate the current working capital base.
• Avoids seller windfall. Seller’s $11.6M peg could cause Kestrel to pay for normal June working capital as if it were excess. Compared to the proposed $15.9M June peg, the gap is ~$4.3M.
• Clean purchase agreement mechanics. Actual closing NWC should be calculated consistently with GAAP and historical practice, but adjusted for identified items including AR reserve adequacy, unresolved AR subledger differences, disputed credits, unearned revenue, and any corrected revenue cut-off.

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(3) Talking Points Script — Revenue Timing Discussion with CFO and Banker

Opening / tone

“Thanks for walking us through December. We want to be clear upfront: we are not assuming intent or alleging misconduct. Our focus is simply whether the revenue was recorded in the correct period under Brightwater’s revenue recognition policy and GAAP, because it affects adjusted EBITDA, lender compliance, bonuses, and the purchase price.”

State the facts

“In our December cut-off sample, we reviewed 34 invoices from Dec. 26 through Dec. 31 totaling about $1.12M. Five invoices totaling $0.14M appear to have shipped Dec. 29 or Dec. 30 and look fine based on the documents we saw. But 29 invoices totaling $0.98M have bills of lading or carrier pickup dates from Jan. 6 through Jan. 14. The related invoices had blank ship-to dates or were marked ‘will call’ or ‘hold.’”

“We also understand the December books were held open for about three extra days, and there was a $0.31M January credit memo / reversal batch described as ‘customer requested date changes.’ We need to understand whether that overlaps with the invoices we sampled.”

Explain why it matters

“If the $0.98M was not shipped, picked up, or otherwise controlled by the customer until January, then it appears the revenue belongs in January, not December. At the stated 27% gross margin and roughly 4% variable selling cost, the EBITDA impact is about $225K. At the deal multiple, that is roughly $1.6M of value.”

“It also matters because reported full-year revenue was $71.4M, and the bonus trigger was $71.0M. Moving these invoices to January would put full-year revenue at about $70.4M before considering any other adjustments. We are not drawing conclusions on motivation, but we do need to understand the accounting and any bonus accrual implications.”

Ask for support

“To get comfortable, we’d like the following for the 29 invoices: customer POs, shipment terms, bill-and-hold or will-call documentation if applicable, customer-requested hold instructions, evidence the goods were complete and segregated by Dec. 31, evidence title and risk of loss transferred before year-end, proof the goods could not be redirected to other customers, and subsequent collection status.”

“We’d also like the full January credit memo batch detail, tied to the original invoices, so we can determine whether any reversals overlap with our sample.”

Set expected resolution

“If the support shows valid bill-and-hold treatment or customer control transfer before year-end, we will evaluate that. If not, we would expect to reclassify those sales to January for QoE purposes and adjust EBITDA accordingly. We would also need the bonus pool amount and covenant calculation so we can understand any knock-on effects.”

Close constructively

“Our objective is to get to a defensible number that both sides can stand behind before signing. The cleanest path is to jointly trace the sample, agree the revenue cut-off treatment, and then reflect any adjustment consistently in EBITDA, NWC, bonuses, and the purchase agreement reps.”

MEMORANDUM

To: Dana Whitfield, Partner, Kestrel Ridge Partners From: [Your Name], Lead FDD Associate Date: [Current Date] Subject: Brightwater Supply Co. – Top 3 Financial Due Diligence Findings & NWC Peg

Dana, Based on our initial diligence of Brightwater, we have identified material issues in the sell-side QoE. The seller’s adjusted EBITDA of $7.7M is overstated, and their proposed NWC peg is artificially depressed to trigger a massive seller-favorable true-up at our target June close.

While we cannot conclude intent, the timing of these accounting anomalies correlates directly with the thresholds required to trigger management bonuses and clear the company’s year-end bank covenants.

Top 3 Findings Impacting Valuation and Deal Structure

1. December Cutoff Error / Premature Revenue Recognition ($1.58M EV Impact + Covenant Risk)

• The Issue: The company held the December books open by ~3 days. Based on our shipping log sample, $0.98M of December revenue (across 29 invoices) actually shipped between Jan 6 and Jan 14. We cannot conclude if this was intentional, but under GAAP, this revenue belongs in January.
• Financial Impact: Reversing this $0.98M out of LTM revenue (applying their 27% gross margin less 4% variable selling costs) reduces EBITDA by $225K. At our 7.0x multiple, this reduces Enterprise Value by ~$1.58M. *(Note: We sampled 80% of invoices >$15K; extrapolated to the full population, the EBITDA hit could be ~$280K).*
• Deal Mechanics Risk: Removing this $0.98M drops FY revenue to $70.42M—meaning management *missed* their $71.0M bonus threshold. Furthermore, the $225K EBITDA reduction likely drops their December fixed charge coverage ratio (FCCR) below the bank’s 1.20x minimum, meaning the company may currently be in technical default with Fifth Ohio Bank.

2. Unreserved Bad Debt & AR Dispute ($620K+ Dollar-for-Dollar Purchase Price Impact)

• The Issue: The largest customer, Delmar Mechanical, has a $1.1M balance, of which $770K (70%) is >60 days past due. The staff accountant noted an ongoing pricing dispute that has not been booked. Total AR reserve is only $150K.
• Financial Impact: There is an unreserved exposure of at least $620K ($770K past due less $150K total reserve).
• Structural Fix: We must explicitly carve out "AR aged >60 days" or specifically "Disputed Delmar Balances" from the definition of deliverable Net Working Capital. If we do not, we will pay cash for dead AR at close.

3. Flawed NWC Peg & Seasonal Closing Drain ($500K Deficit + ~$3.5M Cash Outflow Risk)

• The Issue: The seller proposed a flat NWC peg of $11.6M, claiming it is a Trailing 12-Month (TTM) average. However, the math does not tie out. The actual average of the 12 monthly periods provided is $12.1M. The seller appears to have excluded peak summer months to artificially lower the peg.
• Financial Impact: Agreeing to the $11.6M peg hands the seller an immediate $500K value transfer. More importantly, because we are targeting a June 30 close (historical June NWC is ~$14.9M), closing against *any* 12-month average peg means actual closing NWC will outstrip the peg by roughly $2.8M to $3.5M. Kestrel must model this seasonal cash requirement into the sources and uses today, as we will have to fund this surplus to the seller at closing.

--- Appendix: Additional Watchlist Items

• Sell-Side QoE Credibility: Tolliver & Marsh’s QoE explicitly stated "no revenue recognition concerns noted." Given we found $1M of cutoff errors in basic shipping logs, we cannot rely on their QoE preparer. We must expand our own proof-of-cash and revenue procedures.
• January Credit Memos: $310K in credit memos were batched in early January for "customer requested date changes." This is likely the reversal of a portion of the premature December revenue, validating the cutoff error.
• AR Sub-ledger Disconnect: The AR sub-ledger hasn't tied to the GL since September (variance of $210K). This reflects poor internal controls and complicates the closing balance sheet true-up.
• DSO Degradation: Days Sales Outstanding stretched from 41 days (two years ago) to 54 days this December, signaling cash conversion issues or mounting bad debt beyond Delmar.

Proposed Net Working Capital Peg

Recommendation: A strictly defined, historically adjusted 12-month average (LTM) peg.

• Proposed Peg Number: $11.1M
• Justification & Methodology: HVAC distribution is highly seasonal. Using an LTM average is standard market practice so neither buyer nor seller is penalized by the closing date. However, we must use the *mathematically correct* average ($12.1M unadjusted) and normalize it for our QoE findings:

1. *Remove Delmar Exposure:* We must deduct the ~$770K disputed Delmar balance from all historical months where it was aged/disputed.
2. *Fix December Cutoff:* We must adjust historical December NWC by removing the premature $980K in AR and adding back the corresponding inventory at cost (~$715K), reducing December NWC by $265K.
3. *Definitional Protection:* The Purchase Agreement must define Current Assets to explicitly exclude "Accounts Receivable aged greater than 60 days past due."

*Note to Deal Team:* Even with an adjusted peg of $11.1M, historical June NWC is heavily elevated ($14.9M last year). Be prepared for a massive closing true-up payment to the seller of roughly $3.8M. This is seasonal inventory we will sell down in Q3/Q4, but we must have the day-one liquidity to fund it.

Talking Points Script: Addressing Revenue Timing with Seller CFO & Banker

*(Tone note: Collaborative, inquisitive, non-accusatory. We are seeking "clarification" on accounting policies.)*

• "Hi [CFO Name] and [Banker Name], thanks for taking the time. We've been working through the AR and revenue data to get comfortable with the year-end cutoff. We’re hoping you can help us understand a specific batch of late-December invoices."
• "In tracing a sample of December invoices over $15k to the shipping logs, we noted about 29 invoices, totaling roughly $980k, that were billed in December, but the bills of lading indicate carrier pickup dates between January 6th and January 14th."
• "Under standard GAAP, control and revenue recognition typically pass when the product ships. Can you walk us through Brightwater's specific revenue recognition policy? For example, were these explicit 'bill-and-hold' arrangements requested by the customers, or were the books held open to capture early January shipments?"
• *(If they say bill-and-hold)*: "Got it. For bill-and-hold to qualify under GAAP, there usually needs to be a written customer request and the inventory must be segregated. Do we have that documentation for these?"
• *(If they say it was a mistake/timing difference)*: "Understood, cutoff timing differences happen, especially at year-end. Because this shifts roughly $225k of margin from this year into next year, we'll need to reflect this adjustment in both the LTM EBITDA calculation and the NWC peg to ensure everything is matched to the proper period."

Brightwater Supply Co.: Financial Due Diligence Deliverables

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1. Memo to Dana Whitfield

To: Dana Whitfield, Partner | From: FDD Lead | Re: Brightwater: three findings that change price or structure

Bottom line: I do not recommend signing on the current terms. Three findings put roughly $6.5M–$7.3M at stake against the seller's proposal, about 12–13% of the $54M EV. One unresolved COGS question could make Finding 1 much larger. None of these findings requires us to conclude intent, and I have not done so.

Finding 1: December revenue was recognized before shipment. EV impact is $1.6M–$2.0M, and it raises covenant and bonus problems.

• What we tested: We sampled 34 invoices totaling $1.12M, dated Dec 26–31. All of them have a blank ship-to or are marked "will call/hold."
• What we found: 29 of those invoices ($0.98M) have carrier pickup dates of January 6–14. That is $0.98M confirmed. If our sample of about 80% is measured by value, the extrapolated total is about $1.23M.
• Cross-check: December was up 22% over November, against a historical pattern of flat to down 3%. That implies $1.1M–$1.25M of excess revenue, which is consistent with the sample.
• Other indicators: Inventory units were flat from November to December, a $0.31M credit-memo batch was posted in early January for "date changes," and the books were held open about three extra days.
• Sizing: At 27% gross margin less 4% variable cost, FY EBITDA is overstated by $0.23M–$0.28M. At 7.0x, that is $1.6M–$2.0M of EV.
• Downside case: If COGS was not relieved on these invoices (flat inventory units suggest it may not have been), the EBITDA overstatement is $0.94M–$1.18M. At 7.0x that is $6.6M–$8.3M. This is the first item we must close.
• Structure consequences:
• Corrected FY revenue is about $70.4M, which is below the $71.0M bonus trigger.
• Covenant headroom is only 1.6% (1.22x against a 1.20x minimum). Even if the full $7.7M EBITDA were the covenant numerator, the correction takes FCCR to about 1.18x, a likely breach on the audited test.
• What we cannot conclude: Whether this was permissible bill-and-hold under ASC 606, error, or something else. That depends on customer requests, shipping terms and segregation, none of which we have yet.
• Asks:
• Restate FY EBITDA, or re-price on a properly cut-off LTM June.
• Make audited FY statements and a lender waiver (or confirmed payoff) conditions to signing or closing.
• Treat any FY bonus as a seller cost.
• Obtain a specific indemnity, since R&W insurance will exclude a known issue.

Finding 2: The seller's peg is mismatched to a June close. Impact is $4.1M of closing cash.

• The seller's $11.6M peg is a trailing average that drops two peak months. The full TTM average is $12.1M, so the seller's own method understates by $0.5M.
• The more important problem is the closing date. We close at the seasonal peak, where normalized June NWC is about $15.7M.
• With an $11.6M peg, we would pay roughly $4.1M at close for the normal seasonal build. That build unwinds and then rebuilds within the first year, so the money is never recovered.
• Ask: A month-by-month seasonal peg schedule (Section 2).

Finding 3: AR quality issues total $0.8M–$1.2M, with a possible run-rate EBITDA effect.

• Delmar

Memo to Dana Whitfield

Subject: Key Findings Affecting Brightwater Supply Co. Acquisition

1. Potential Revenue Overstatement in December

• Issue: December sales analysis indicates potential revenue recognition issues. 29 out of 34 invoices totaling $0.98M have shipping dates between early January, suggesting revenue was booked prematurely.
• Impact: Adjust EBITDA downward by reversing these sales, impacting revenue and EBITDA. Estimated adjustment: $264K reduction (assuming a 27% gross margin and adjusting for $0.04M variable selling costs).
• Consequence: This reduces pro forma EBITDA to approximately $7.44M, influencing valuation by $1.8M (at a 7.0x multiple).

2. Accounts Receivable Concerns

• Issue: Significant aging in AR with 21% over 30 days and a dispute with Delmar Mechanical impacting $1.1M, which is considered a critical risk.
• Impact: Need to increase bad debt reserve for disputed AR. A prudent estimate is reserving an additional $0.385M (70% of Delmar's disputed balance), which could reduce EBITDA by another $0.385M, impacting valuation by approximately $2.7M.

3. Working Capital Peg Discrepancy

• Issue: Seller proposes a NWC peg of $11.6M based on selectively excluding two high months. The unbiased trailing 12-month average is $12.0M.
• Impact: Insist on a peg of $12.0M, reallocating $0.4M more capital to be held aside at closing, affecting cash flow available for debt reduction or investment post-close.

Appendix: Other Observations

• December revenue increase potentially linked to the triggering of management bonuses.
• AR sub-ledger misalignment of $210K needs reconciliation.
• Minimal inventory changes suggest limited risk from obsolete stock but require verification.

Proposed NWC Peg

Proposed Peg: $12.0M

Justification: This figure accounts for the full 12 months, avoiding manipulation through selective exclusion and better reflecting the company's operational working capital needs over time.

Script for Revenue Timing Issue Discussion

Introduction: "As part of our standard due diligence and given the proximity to year-end reporting, we've identified some concerns with the timing of certain December sales."

Evidence: "Our review of shipping logs shows that a notable portion of high-value invoices billed in December were not shipped until January. Specifically, 29 invoices totaling $0.98M were involved."

Impact: "We understand that operational realities might necessitate post-dated shipping; however, these timing elements directly affect recognized revenue and related financial metrics, necessitating a review of the reported EBITDA."

Proposal: "We recommend adjusting for these discrepancies to ensure a fair representation of financial performance, subject to further discussion and reconciliation."

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Next Steps: Validate and address noted discrepancies during ongoing due diligence, adjust offer terms as necessary, and prepare for post-close integration while mitigating identified risks.

Deliverable 1: Memo to Dana Whitfield (one page)

To: Dana Whitfield | From: Lead FDD Associate | Re: Brightwater: do not sign at $54.0M / 7.0x on the seller's package