‘Cash free/ debt free’ adjustments are commonplace in M&A transactions. Here we looks at what that phrase means and highlights some of the uncertainties that should be resolved when buying a business on that basis.
We can probably all agree on the broad principle of a ‘cash free/ debt free’ deal. A price is agreed which represents the underlying value of the target’s business and which assumes that there will be no cash in the target (this will be extracted by the seller) and, similarly, the target will have no debts (these will be cleared by the seller before completion).
So far, so easy.
The problems come when you try to agree on what is meant by cash and, perhaps even more controversially, what is meant by debt. And generally the parties don’t actually mean that all cash is removed or all debt repaid, but instead are only concerned with excess amounts above an agreed level of normalised working capital. (Working capital being the amount that the target company needs to finance the running of the business on a day-to-day basis.)
Cash is cash, right?
While it might be tempting to rely on the target’s bank statements to measure its cash, this will not take into account items ‘in transit’, such as unpresented cheques (whether debits or credits) or cash floats in tills. The target may also have other items which, while not strictly cash, are capable of being turned into cash on very short notice (‘cash equivalents’ in accounting terms). The seller would want these to be considered when calculating the target’s cash level.
On the other hand, if a business is required to carry a certain amount of cash for regulatory or legal reasons (for example, cash securing a rent deposit), the buyer may be reluctant to pay for this ‘trapped cash’ which will not form part of the target’s usable working capital post-completion.
All debts are equal, right?
There are broadly two categories of debt in a business:
- financing debts, such as bank loans or asset-backed lending arrangements; and
- debts arising in the ordinary course of business, such as debts due to suppliers, service or utility providers, rent, etc.
When assessing the debt-free element of a deal, the parties are generally concerned with the former category of finance debts rather than trading debts which are just part of the everyday commercial activities of the target and which should not be the subject of a price adjustment. But there may be types of debt which are hard to categorise definitively one way or the other (for example, hire purchase agreements or finance leases, preference shares or intra-group loans). There is no precise rule for how many of these items should be treated (and what value should be attributed to them) and ultimately it will be a matter of negotiation between the parties and their financial advisers.
All or nothing?
Typically, when parties talk about a ‘cash free/ debt free’ deal they don’t actually mean that the target will be left with zero cash or debt. The buyer will be concerned to ensure that, when it takes over the target at completion, it has an adequate level of working capital to allow it to carry on its operations. Again, what the parties will consider “adequate” will be subject to negotiation but the outcome of that negotiation will inevitably mean that at least some cash is left in the target together with trading debts arising in the ordinary course of business.
As noted above, whilst the term ‘cash free/ debt free’ implies there will be no excess cash left in the target and the target will have no excess debt, in reality cash may not actually be extracted nor debt actually repaid before completion.
Instead, completion accounts may be used to measure the amount of excess cash and excess debt (based on the agreed definitions of those terms) in the target at completion. The amount of excess cash will be added to the purchase price (so the buyer effectively pays for this) and the amount of excess debt will be deducted from the purchase price (so the seller bears the cost of that debt passing to the buyer). There will usually also be an adjustment based on the target’s actual level of working capital as at completion (as compared to the ‘adequate’ level agreed by the parties.)
However, paying for cash is not an efficient structure for the buyer: it will increase the amount of funding required to pay the purchase price (so the buyer will be paying to borrow cash to buy cash) and, on a share purchase, it will increase the amount of stamp duty payable by the buyer (which is calculated by reference to the purchase price of the shares). So the buyer may prefer the seller to extract excess cash before completion. This could be achieved via a dividend, a repurchase of shares, a repayment of any loan made by the seller (which would also help to ensure the deal was debt free) or even a contribution to the pension schemes of an individual seller.
Excess cash could also be used to repay any excess debt in the target before completion or the debt could be repaid on completion out of the agreed purchase price (backed up by suitable contractual provisions and undertakings.)
The devil is in the detail
A ‘cash free/ debt free’ structure is a simple concept, but make sure you avoid any complications by ensuring everyone agrees on exactly what is meant by the terms used.