Cash Free Debt Free Basis
On an acquisition, it is usual for the initial purchase price offered to be stated on a ‘cash-free debt-free’ basis. In simple terms, this means that any cash in the business is retained by the seller and that all debt is repaid by the seller upon completion.
Most deals also involve a purchase price adjustment mechanism in relation to working capital. When buying a company on a ‘going concern basis’, acquirers will be keen to ensure that they are purchasing a business that will have sufficient working capital to fund its trading cycle from day one of their ownership.
What is normalised working capital in M&A?
In order to protect against the nasty shock of having to inject cash into the business on or shortly after completion, the buyer will need to establish the ‘normalised’ working capital levels. Once this target working capital figure has been arrived at, it is important to define what will happen in the event of the target not being met. Usually, any increase in working capital over and above the target figure calculated at the offer stage and the actual figure at the completion date will result in the purchase price being increased on a pound-for-pound basis, and vice versa in the event of a shortfall against the target figure.
Whilst, in theory, the calculation of the ‘normalised’ working capital level is straightforward, it is often not the case, with the determination becoming a contentious area to which buyers need to pay close attention.
The starting point for determining the working capital level of a business is to identify the assets and liabilities included in the calculation. Working capital is most commonly defined as net current assets (excluding cash) adjusted for any debt-like items such as corporation tax liabilities, loans and hire purchase liabilities. The target working capital figure can be arrived at in several ways, for example the figure at an agreed date or on a rolling-average basis, normalised for any one-off items that may distort the figure. However, every deal is likely to be different and therefore care must be taken at the outset of the transaction to agree the method of calculation.
Following completion of the transaction, it is usually the responsibility of the seller to produce completion accounts (which can sometimes be subject to audit) as at the date of completion. At this point, the actual working capital level on the date of completion will be known and can be compared to the agreed target number, following which a purchase price adjustment will be made.
In practice, these matters often mean that the final amount of cash paid for a business by the purchaser (and of course received by the seller) is somewhat different to the headline price offered at the start of the process. To avoid any misunderstanding and potential disagreements at completion, it is critical that the initial offer (usually contained in a Heads of Terms or offer letter) contains clear and defined terms in relation to the purchase price and any subsequent potential adjustments.
An alternative approach, which is becoming more common, is the locked-box mechanism. The key difference is that the final adjustments to the amount paid for a business are applied using a balance sheet at a date prior to completion; this is termed the ‘locked-box balance sheet’. This mechanism is most common in transactions where there might be multiple bidders, or the seller is an investor (such as private equity) as it gives certainty on the final price at completion. The process of agreeing the net cash and any working capital surplus or deficit is the same as when using completion accounts but it is based on the locked-box balance sheet rather than completion accounts.
It is essential to protect the buyer from cash or other assets being extracted from the business between the locked-box date and completion. This is referred to as ‘leakage’, the most common example being cash paid out in the form of dividends. Suitable protection is typically built into the Sale and Purchase Agreement.
An important feature of the locked-box mechanism is how to deal with any change in the value of the business due to trading between the locked-box date and completion; this is often referred to as the ‘value accrual’. Normally the value accrual is based on the post-tax cash generated in the post locked-box period.
Finally, the date of the locked box should be carefully considered. Due to the absence of an adjustment mechanism post completion, a buyer should carry out sufficient due diligence on the locked-box balance sheet to be comfortable it is accurate. It is advisable that the locked-box date is not too far in the past as this would increase the risk of leakage and the risk of actual profits being materially different from the value accrual.
Whether a completion accounts or locked-box mechanism is being used, it is important to take advice early to avoid problems and reduce the risk of the transaction failing at the end of a lengthy due diligence process.
If you would like to discuss any of the issues raised in this article, please get in touch with Ross Lane, Mike Orton or your usual contact at Mercer & Hole.