Cash-Free, Debt-Free in M&A
By: Tyler Clement
Owners of a company are exploring a sale. They have hired an investment bank to market the company and are at the point in the process where offers are due. They know that the offers are going to provide a proposed value of the business, likely based on a multiple of the Company’s EBITDA. When the offers come in, the owners are surprised by the inclusion of an additional distinction in each offer: the potential buyers are all proposing to purchase the business on a cash-free, debt-free basis.
What Do We Mean by Cash-Free, Debt-Free?
Cash-free, debt-free is a term that means a buyer is acquiring a business and valuing it based on the business's operating assets and liabilities required to generate cash flow. A simple way to view this term is that the seller will be entitled to extract all the cash on the company’s balance sheet at close and will be responsible for paying down any debts. A buyer will acquire all the selling company's operating assets, including current assets such as inventory and accounts receivable, as well as long-term assets like property, plant and equipment. The buyer will also assume all operating liabilities like accounts payable, accrued payroll liabilities, and accrued expenses.
All non-operating balance sheet items within the company remain with the seller. This includes cash & cash equivalent accounts (i.e., investment accounts, petty cash, etc.) and debt. In these cases, debt is frequently senior bank debt but can include other forms of debt financing such as subordinated debt, shareholder loans, unpaid dividends, and more. In some cases, the seller will be required to pay off non-operating liabilities at closing, especially in the case of bank debt. This typically occurs by a portion of the purchase price being directly wired to the bank at close to pay off any outstanding loans.
The term cash-free, debt-free will commonly be included in tandem with the buyer requiring a “normalized” net working capital. The exact amount of the “normalized” net working capital is mutually agreed upon by both parties during the negotiation process but will exclude cash and non-operating liabilities. An example of how this may be phrased in an offer letter from the buyer is: “acquiring 100% of the Company from Seller, structured as a cash-free, debt-free transaction, and assuming a normalized level of working capital.” Almost all M&A deals are negotiated on this cash-free, debt-free basis, and more on normalized net working capital can be found here.
Why Transactions Are Cash-Free, Debt-Free
Excluding cash and debt delivers the business to the buyer on a true enterprise value basis. Said another way, the buyer is valuing the business at close only on the operating assets and liabilities on the balance sheet that are used to generate ongoing cash flow. Additionally, most buyers value companies off a multiple of EBITDA. As we describe at a high level here, EBITDA excludes interest expense related to company debt payments. Thus, EBITDA provides buyers a proxy for cash flow without the impact of debt, and consequentially buyers will only be buying assets and liabilities that are utilized to generate that cash flow (operating assets and liabilities).
One common question is how does a company operate the day after close if the seller has extracted all cash? How does a company pay an upcoming payroll or vendor payment due shortly after close? There are several ways this can be resolved at the time of closing. In some cases, a buyer may directly fund the new cash account at close to ensure sufficient cash is in place to maintain day-to-day expenses. Other times it may set up a line of credit to be active immediately upon close to allow it to draw on the line if needed. In other cases, the buyer may ask the seller to leave a small amount of cash behind to serve as a comfortable buffer for that first week or so until the buyer is settled into its newly acquired company post-closing. The seller would be reimbursed for any cash it left behind through an increase to the cash received at close as part of the purchase price. Let’s say the buyer was purchasing a company for $30 million (for purposes of this example, we’ll exclude any other items that could potentially adjust the price at closing and focus only on cash left behind). If the buyer asks the seller to have $200,000 of cash remain in the company’s cash account, then the total cash paid to the seller at closing is $30,200,000.
Another common question from a seller is why don’t the sellers get to keep the accounts receivable (“AR”) at the time of close? After all, those are sales that were made prior to closing but just haven't been collected yet. The reason no AR is kept by the seller again goes back to the fact that the buyer is acquiring all operating assets of the business. The buyer is valuing the business off its cash flow, so it will need the operating assets that are used to generate that cash flow. Accounts receivable is one of those operating assets. Therefore, the buyer is essentially paying a multiple of EBITDA to acquire the AR. The other side of this concept is that the buyer will be responsible for paying all accounts payable (“AP”). So, just like the buyer gets to retain AR for sales prior to closing, the buyer will need to fulfill AP on items purchased before closing.
The term cash-free, debt-free can be confusing at first as it may seem to imply that no cash or debt is involved at closing. Buyers still have the option to finance the purchase with debt, and the selling company will still have cash on its balance sheet in some fashion on the first day post-closing. Nonetheless, this industry term is typically the agreed upon way a business will be transferred from buyer to seller at close. It is one of the many nuances that occurs at closing that an owner selling a company for the first time will need to understand.