Most private M&A transactions are undertaken on a debt free, cash free basis.
This means the vendor pays out any debt at completion and keeps any remaining cash in the business (typically by way of a pre-completion dividend).
The purchaser will also require a “normal” level of working capital to be maintained in the business at completion. To the extent that the business includes cash or debt at completion, adjustments to the purchase price are required for the consideration to reflect the change to the debt free, cash free value arising from this cash or debt.
The value of a business on a debt free, cash free basis is also known as the Enterprise Value and ensures that the business is valued independently of its capital structure. After the appropriate adjustments for net debt (or net cash) and working capital, the amount the vendor actually receives represents the equity value.
Whilst determining the value of a business on a debt free, cash free basis appears to be straight forward, there are no commonly accepted definitions of cash, debt, working capital or normal working capital and these terms are rarely fully defined in a letter of offer. Consequently, these critical terms are often defined and negotiated during due diligence and drafting of the sale and purchase agreement.
Often the vendor and purchaser will have different expectations of these definitions and how the deal mechanism will work at completion. This ambiguity can cause misunderstandings and angst between the parties with the potential for pre-completion deal-breaking issues to arise or for a shift in value to occur between the parties at completion resulting in post-transaction disputes. Therefore, it is critical that net debt and working capital are clear focus points during due diligence.
An experienced due diligence provider can identify and quantify potential adjustments and assist you to negotiate the sale and purchase agreement accordingly.
Why is net debt and working capital at completion important?
Debt, in the first instance, means financial (or interest-bearing) debt. At first glance, this would include term loans, overdrafts, interest-bearing or non-interest-bearing loans from related parties etc.
However, we need to remember that the vendor is potentially walking away with all the cash in the business at completion. Consequently, the purchaser needs to carefully consider what liabilities will need to be met after completion.
In the absence of cash on the balance sheet at completion, payments of liabilities post-completion can only be funded from three sources (assuming no realisation of surplus assets):
The conversion of working capital into cash.
New funds injected into the business (debt or equity).
Cashflow/profits from operations post-acquisition.
New funds injected into business post-completion to pay pre-completion liabilities represent an additional investment and effectively increases the price paid for the business. Accordingly, the purchaser needs to ask two very important questions:
- Will a sufficient level of working capital be available at completion so that the cash generated from working capital assets will be sufficient to pay working capital liabilities in the ordinary course of business (note that short term timing issues can be met by way of an overdraft)?
- Are there any liabilities at completion (on or off-balance sheet), in addition to financial debt, that will be not be funded by working capital and, therefore, require cash to be retained on the balance sheet at completion in order to settle the liability without the new owner committing additional funds?
Liabilities of the nature described in point two are called debt-like items (sometimes referred to as quasi debt). Whilst not technically financial debt, these items will require funding post-completion and represent, in a practical sense, debt or a liability to the new owner.
Examples of debt like items:
Income tax liabilities – at completion, there will typically be a liability for income tax on any untaxed profits generated up to completion. If the vendor simply walks away with all the cash at completion, the purchaser will need to fund the payment of the income tax liability that relates to pre-completion profits. Clearly, this would represent an unfair outcome for the purchaser and represents a shift of value in favour of the vendor.
Deferred revenue – If the target business receives cash from customers in advance of supplying a service, the cash received in advance represents a liability. That is, the target needs to perform a service to settle its obligation, which will usually involve incurring a cash cost.
- If there is no adjustment at completion to reflect this cash cost, the vendor will walk away with the cash at completion but the buyer will be left to supply the service at its own cost. This would represent a shift of value from the purchaser to the vendor.
Overdue creditors – say the target company has negotiated 90-day terms with a supplier and this arrangement has been in place for a long period of time. At first glance, this might appear to be reasonable on the basis that “normal” historical working capital will reflect this arrangement.
- However, what if the supplier in question had struck a special deal with the vendor and seeks to renegotiate the terms post-completion to a more normal level of 30 days now that the business is owned by a new party? In this case, the new owner will need to fund the shortfall in working capital as terms move from 90 to 30 days.
Long service leave – long service leave represents a provision for the cost of funding employees’ long service entitlements. Whilst historical profits should reflect the cost of long service leave as an expense when it is incurred (as opposed to paid), the cash cost will be borne at the time the entitlement is paid. If the vendor walks away with the cash at completion, without an adjustment for this cost, the cash cost will be met by the purchaser. However, the vendor has received the cash benefit associated with the provision.
- Other examples that need to be considered include outstanding cheques, contingent liabilities, earn-out payments, accrued interest, accrued bonuses, make good provisions, credit cards, unusual warranty claims, annual leave liabilities and capex commitments or requirements.
- There is a myriad of issues to consider when identifying and quantifying debt-like items. The ultimate adjustment to the purchase price at completion will be determined primarily by negotiation of the sale and purchase agreement. A critical examination of debt like-items is vital to ensure a purchaser is not adversely disadvantaged through the transaction process.
The concept of debt free, cash free is inter-related to the normal working capital requirement of the business.
Completion adjustments need to be considered for both the net debt position and the working capital position for a transaction to be completed on a debt free, cash free basis. By way of example:
- If at completion, a business has a higher than normal level of working capital (say a creditor is paid earlier than normal just prior to completion), the purchaser will generate a cash benefit when the working capital returns to a normal level and cash temporarily tied up in working capital is released.
- Conversely, if at completion, a business has a lower than normal level of working capital (say a large trade debtor pays earlier than usual) the vendor will walk away at completion with cash that is actually part of the normal working capital requirement. This shortfall will need to be funded by the purchaser.
The first point above represents a shift of value at completion from the vendor to the purchaser. The second point represents a shift of value to the vendor from the purchaser.
A review of historical and forecast working capital as part of the financial due diligence process is critical to understand the on-going working capital requirements post-acquisition and ensure that a purchaser acquires a business with sufficient working capital at completion. Businesses impacted by seasons, lumpy revenue streams, or where new significant new contracts have been recently won will require careful consideration of working capital issues.
The completion mechanism
In order to ensure that a transaction is completed on a debt free, cash free basis, there is typically a choice of two completion mechanisms used in a private transaction:
- Completion accounts;
- Locked box.
Cash, debt and working capital (including the working capital target amount) are defined in the sale and purchase agreement.
Financial accounts are prepared as at the completion date and the purchase price is adjusted on a dollar for dollar basis of actual working capital and net debt at completion. The completion adjustment is effectively a true-up of the consideration at completion to arrive at the agreed purchase price of the business on a debt free, cash free basis.
It is critical that the sale and purchase agreement is carefully drafted so that each party has a clear understanding of the basis of preparation of the completion accounts and the definition of each component of debt and working capital.
A locked box transaction uses the historical accounts of the target at a point in time prior to completion as the reference point to calculate the equity value.
Net debt and working capital items are defined with reference to the historical balance sheet and any resultant adjustment to the purchase price are “set in stone”. This position is then “locked” which effectively means that all economic benefits of the business are for the benefit of the purchaser from the date of the locked box balance sheet.
For the box to be locked no “leakage” can occur (except for leakage that is expressly agreed, such as a pre-completion dividend). On the completion date, the purchase price is paid by the purchaser to the vendor inclusive of the agreed net debt and working capital adjustment. Other than warranty or indemnity claims, no further adjustment is made to the purchase price.
Whilst the mechanisms set out above have different advantages and disadvantages, the concept remains the same and a large portion of the purchase price may depend on the final definitions of cash, debt, debt-like items and working capital.
There are no commonly accepted definitions of these terms and the letter of offer rarely addresses these complexities. Definitions in the sale and purchase agreement will determine the final purchase price and it is this agreement that will be relied upon to resolve any post-completion disputes.
There can be strong arguments from both the purchaser and vendor as to whether an item represents working capital or is a debt-like or cash like item. The earlier these matters are identified and discussed, the smoother the deal is likely to be. Alternatively, if the issues are deal-breakers, early identification will limit the time, effort and cost incurred on a failed transaction.
Regardless of the completion mechanism, working with your due diligence provider to define the scope of financial due diligence is critical to understanding a target company’s working capital requirements and net debt and debt-like items.
If you have any questions regarding debt free, cash free transactions contact your local RSM office.