If you’re an investment director at a fund, a large corporate considering acquisitions, or you are an owner of a business who has been approached by a potential buyer of your company, then you might find yourself negotiating the key fundamentals of the transaction in a letter of intent (LOI) or term sheet. The LOI or term sheet may contain the words “the purchase price has been calculated on a debt free cash free (DFCF) basis, with an agreed level of working capital” or something similar.
If you’re new to the world of mergers and acquisitions (M&A), then you might not fully understand what this means. Before signing any LOI or term sheet, it is fundamental to understand what impact the cash free debt free mechanism will have on the final consideration payable for the target company.
What does debt free cash free mean?
Debt free cash free transactions have become increasingly popular in Australia and in similar jurisdictions across the globe. It has become a well understood framework for establishing equity value in private M&A transactions and therefore allowing for calculation of the final purchase price to be paid by the buyer.
A common basis for valuing a target business is to calculate its enterprise value based on a multiple of earnings before interest, tax, depreciation and amortization (EBITDA). The enterprise value is what a buyer would be willing to pay for the shares in the target company, assuming the company had no debt and no cash on completion. This valuation methodology allows a prospective buyer to compare companies that may have very different financing structures. The buyer can determine what it is willing to pay for the earnings being generated by the company assuming the financing structure the buyer will utilize moving forward (as opposed to the target’s financing structure).
The buyer may require the target company to repay shareholder loans and third party debt and pay its free cash out (via dividends) prior to completion, but a company will never actually have no debt and no cash on completion. Therefore the purchase price that will actually be paid by the buyer needs to be determined by taking the enterprise value (or “headline price”) and reducing it by the value of debt and debt-like items and adding back the amount of free cash available in the target company. Debt like items can include things such as income tax liabilities, deferred revenue, overdue creditors, long service leave and transaction costs. Cash includes items such as funds available in bank accounts, term deposits etc. but there may be negotiation over amounts held as security by landlords or held to support a bank guarantee.
The basis on which the purchase price is calculated is very important for a seller of a business not familiar with M&A transactions to understand so that they can estimate the final purchase price they will likely receive and whether or not this meets their expectations. Occasionally, a seller will sign a LOI or a term sheet without seeking professional advice and are surprised to learn that the headline purchase price will be reduced by any debt in the business. This can cause difficulties between buyer and seller once it comes time to work through the sale and purchase agreement and may even create a “deal-breaker” situation. It is best for all parties to be clear on the DFCF mechanism early in the process and even work through some rough calculations in a spreadsheet so that there are no misunderstandings.
Target working capital
A buyer will usually also require a certain amount of working capital in the business on completion sufficient to enable the buyer to continue to finance and run the business. It is also important to adjust the purchase price based on the level of working capital in addition to the debt and cash position, as otherwise there is a risk of manipulation of the final purchase price by virtue of maximizing the cash position and minimizing the debt position. For example, the seller in a transaction may be incentivized to seek payment from all of its debtors but delay payment of its creditors, thereby increasing the free cash available. These movements in debtors and creditors will be captured if there is also an adjustment for working capital against a defined target.
The working capital target or “peg” is usually based on an average working capital calculation over a trailing twelve month period (subject to seasonality and other considerations). The buyer and seller will also usually “normalize” the historical working capital calculations by adjusting for one-off or extraordinary events.
The actual working capital of the target company is then calculated on completion by preparing completion accounts in the 30 – 90 day period after completion. To the extent the actual working capital is less than the target working capital, there will be a deduction from the purchase price equal to the shortfall and to the extent actual working capital is more than the target, an increase in the purchase price equal to the amount over and above the target level of working capital.
Quick tips
When it comes to documenting a DFCF deal in a sale and purchase agreement, there are several key items that require specific consideration to ensure the final transaction documents reflects the parties’ expectations of the deal:
- The parties should agree on very specific definitions for “debt”, “cash” and “working capital”. In smaller transactions, the parties sometimes use these terms without including detailed definitions. This can lead to disputes during completion calculations, particularly as to what constitutes “debt”. Preferably, the sale and purchase agreement will include a pro-forma balance sheet which records each balance sheet line item and indicates which measure it falls into or whether it is to be excluded.
- The accounting principles that will be used to prepare the completion accounts are important. This is particularly so where the buyer applies different accounting principles in the preparation of its own accounts to those applied by the target company. Although there can be disagreements about which principles should prevail, generally it is better that the accounting principles applied by the seller in its historical accounts are applied so that you are comparing ‘apples with apples’ when calculating actual net debt and comparing working capital against the target.
- Determining the target level of working capital by a buyer requires careful consideration where the target company experiences seasonality, lumpy revenue or has, or may be, affected by the winning or losing of key customer contracts.
Hamilton Locke regularly advises clients on the buy-side and sell-side of M&A deals to help navigate the nuances of debt free cash free transactions.
For more information, please contact Peter Williams.
