“Debt Free/Cash Free” – a sting in the tail?

Most of the focus in a transaction process is on maximising the value of the business on an Enterprise Value basis. This is usually arrived at by multiplying a profit number (often adjusted EBITDA) by a multiple. It gives a valuation which is comparable from business to business because it takes no account of individual funding structures or free cash balances.

However, the Equity Value (the amount actually due to the shareholders) has to be adjusted for those factors and the calculations around this adjustment can be a matter for great debate and frequently for disagreement, since there is room in it for interpretation and subjectivity.

Anyone who is considering selling their business should be aware of the elements of this calculation and should think about them in context of their own circumstances. Only with a realistic approach to negotiating the debt free/cash free adjustment will a deal happen. It is also an area where careful planning can improve the vendors’ overall outcome.

The principles underpinning the debt free/cash free adjustment are that an acquirer should inherit a business free of structural debt and with sufficient cash (only) to cope with the normal working capital cycle.

Debt to be paid for by the sellers will usually cover bank borrowing (including overdrafts, invoice discounting and other asset funding facilities), shareholder or director loans, intercompany balances, trade loan facilities, Hire Purchase and finance leases. It will also include a deduction relating to corporation tax due on profits to the date of completion

Depending on the circumstances, debt might also include deferred income (where cash has been received in advance and the business has an obligation to provide future products or services), lease dilapidations, deferred tax, accrued bonuses and any fees due for breaking debt facilities.

In order to calculate the amount of cash that the vendor needs to leave in the business to cover normalised working capital requirements, buyers are likely to look back at least a year to determine the scale of both the highest seasonal balance and intra-month peaks. They will not want to take a chance that they will have to invest further to support normal trading and are likely also to look ahead at short term forecast requirements to ensure sufficient cash headroom. Using this analysis they will set a target level of working capital (which normally includes trade creditors, trade debtors and stock) and there will be an adjustment to top this up with cash if the working capital at completion is lower than it needs to be.

Depending on how much cash is in the business, the agreed debt deduction and the agreed working capital adjustment might be taken either as a reduction in the free cash balance to be added to the value of the deal or, if there is insufficient cash in the business to cover it, there will be a deduction from the price.

So far, so straight forward, you might think. Except that there is often a great deal of discussion to be had to get to an agreed set of completion adjustments. For example:

1. Does Deferred income still represent a debt if there is no additional cost to be incurred by the company in delivering the product or service concerned ?
2. Is it reasonable to deduct deferred tax if there is no realistic prospect of the liability needing to be paid ?
3. What about lease or HP debts in asset heavy businesses (such as leasing companies) where the debt is closely associated with assets which are not separately valued in the deal ?
4. How to fairly quantify dilapidations if a business is part way through an arms length lease ?
5. What if trading patterns have changed/are changing and historic peaks are no indication of future ones ?
6. Should a vendor be allowed to include a potential R&D tax credit in the calculation of net corporation tax liabilities ?

I could go on. When all of these individual discussions and negotiations are set alongside each other the gap between a buyer and seller’s interpretation of a fair debt free/cash free adjustment can be sizeable without either of them being “wrong”.

So what can vendors do to ensure that the debt free/cash free adjustment doesn’t come as a sting in the tail at the end of a deal?

First, they can make sure they understand the elements in the calculation and the best case/worst case interpretation of their figures

Second, They can ensure they understand the principle of a buyer not having to inject cash to trade the business normally post deal and manage their business accordingly. To the extent that deferred revenue (for example) is not matched by future liabilities they should endeavour to track and evidence this over time

Third, they can manage their working capital efficiently in the years leading up to a transaction. A short term focus on debtor collection or a clumsy attempt to string out creditors will not work to minimise the requirement but a sustained effort at efficiency over a year or more should have a positive impact on the cash they ultimately get to keep. Spreading regular payments across the month to minimise an intra month peak might be worth considering.

Fourth, if there are mitigating factors in the tax calculation these should be explored and evidence collected to support the arguments, particularly in context of a changing regime or a potential move from annual to quarterly payments.

In short, this should be a focus for would-be vendors in the same way that maximising EBITDA and optimising a multiple tends to be. Starting from a position of knowledge and evidence and fielding compelling arguments with the relevant data is likely to result in the best possible outcome.

At the very least vendors should be aware of this potential sting in the tail and the debate that surrounds it …..

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