By Natasha Dinneen

Almost all M&A deals are negotiated on a ‘cash free, debt free’ basis, but what does that actually mean? What happens to the existing cash and debt in the business being acquired?

Cash free, debt free by its simplest definition means that when a buyer purchases a company and its assets, it is on the basis that the seller will pay off all debt and extract all excess cash prior to completion of the transaction. Excess cash is any cash held by the company being acquired that is in excess of short-term working capital requirements.

What exactly is considered cash? 

Cash held at bank or in hand/petty cash are the most common types of cash. Credit card payments in transit are also considered cash equivalent. Other balances such as rental deposits, short term investments, restricted or ringfenced cash, cash held in foreign bank accounts (where repatriation may be an issue), or escrow cash balances can also be considered as cash or cash equivalent depending on the business. Debtor balances are not typically considered cash until the balance is paid, and are considered as part of the working capital.

Tech Top Tip

Ecommerce companies, who take payments on behalf of customers, usually hold amounts of ringfenced cash which is not typically considered cash as defined above. For example, an online marketplace might accept payments from customers purchasing products on its website then sends the cash collected from each transaction back to the sellers of those products (less a marginal fee). The cash collected from each transaction that is ultimately passed back to those sellers is not considered cash as it does not legally belong to the company. The online marketplace is simply holding the funds on behalf of sellers, so will not be paid for this cash if the marketplace itself were to be sold to another company.

What exactly is considered debt? 

Most commonly debt includes any institutional loans, bank loans, shareholder loans, overdrafts, long term debt or unpaid dividends. Additionally, any cheques that have been issued but not yet cleared are considered debt-like.

Other balances which buyers may argue should be considered debt-like include:

• Outstanding tax liabilities
• Accrued bonuses or commissions
• Other accrued expenses such as transaction fees or holiday pay accruals
• Gift cards
• Financial instruments (interest rate swaps or derivatives)
• Unusual warranty claims
• Office dilapidation provisions
• Deferred revenue
• Letters of credit
• Unfunded pension obligations
• Lease obligations
• Unusual provisions in employee contracts
• Previous acquisition earn out or deferred consideration payments
• Litigation or other contingencies
• Any off-balance sheet liabilities

Trade creditors and intercompany loans are not included in debt, as trade creditors form part of working capital and intercompany balances are settled, netting to nil, on completion.

Why negotiate on a cash free, debt free basis? 

Most deals are structured on a cash free, debt free basis because this structure (reasonably) assumes that the seller is entitled to any existing cash generated over and above the level of cash required to fund the business on an ongoing basis (eg. payroll, creditor payments, other short-term cashflow requirements) and will pay off any debts at completion of the transaction with the funds available after the sale.

This structure also allows competitive bids to be compared on a like-for-like basis regarding valuation. In practice, the deal agreed with the buyer usually includes adjustments for agreed amounts of debt and excess cash left with the company, which can have tax benefits.

Negotiating on this basis is complex, and the definition of cash and debt on completion follows detailed due diligence. The final purchase price of a transaction will depend on the agreed definitions of cash and debt-like items included in the Sale and Purchase Agreement (SPA).

The earlier the seller identifies and discusses the cash and debt-like items with the buyer, the better – as this always leads to smoother negotiation towards close. Honest and transparent due diligence in our experience always puts sellers in a stronger negotiating position and can be more favourable in terms of cash on completion.

Working capital and net debt are tricky topics as well. Keep an eye out for follow-up posts on these in our Demystifying M&A and Jargon buster blog series.