Understanding Cash Free Debt Free in M&A Transactions

Understanding Cash Free Debt Free in M&A Transactions

Shoot The Moon
Shoot The Moon
Understanding Cash Free Debt Free in M&A Transactions

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Today, we’re talking about cash-free debt-free, and what it means in M&A:

  • When an acquirer buys another company, the transaction will be structured such that the buyer will not assume any of the debt on the seller’s balance sheet
  • The buyer will not get to keep any of the cash on the seller’s balance sheet.
  • Most M&A deals are negotiated on a cash-free and debt-free basis.
  • The seller keeps all cash and pays off all debt at the time of the sale of a business.


Mike Harvath  00:04

Hello, this is Mike Harvath with this week’s Shoot the Moon podcast, broadcasting live and direct from Revenue Rocket world headquarters in Bloomington, Minnesota. With me today are my partners Ryan Barnett and Matt Lockhart. Welcome, guys.


Matt Lockhart  00:20

Great to be with you sort of humming along in the early part of 23 here, lot’s of action. I know, Ryan, you’ll introduce the topic, but I think it’s timely because, you know, we’re we’re sort of already in closed, , you know, moving into close deals, cycles here. So pretty exciting.


Ryan Barnett  00:40

Absolutely. It’s one of those times, and the deal we’re talking about today is the consideration of liabilities and cash upon clothes. So oftentimes, they’ll hear a phrase of cash free debt free when you get to a deal. And when you start to get to, I’d say the later strokes in a deal. This is where the cash consideration comes into play for the business. Oftentimes, IT services business, you see a relatively light balance sheet, as there’s often services based business, but there’s still some considerations on what you owe and what you have. So I love Mike, I think you’re a really good expert here. And I’ve seen this quite a bit of work within understanding this. If you just help us out and just start, what is cash free, debt free? What does that actually mean?


Mike Harvath  01:35

Sure, Ryan, thanks. You know, cash free debt free is exactly what it is, it means that at close of an m&a transaction, you as a business owner will take out the cash or the business, strip the cash, but you also not leave the business with any debt. And I have to distinguish between long term debt and trade payables. trade payables are acceptable debt to move over. They include things like your rent for your office space, and they may be a lease even. Some of those are negotiable, it’s a piece of equipment that is considered a payable. And you know, there could be other things like your internet provider, and telephony and things that are what are considered trade payables. Those aren’t counted as debt. But let’s say you went and got a, you know, a big PPP loan, and it’s still sitting on your books, that would be debt. Another thing that a lot of services companies don’t think about as debt are the value of the prepaids that you might get from a client, I call them prepaid, some people call them customer deposits. But if they’re when a client makes a specific deposit with you, or pays for services that haven’t yet been rendered, there is a liability associated with that. And there should be on your balance sheet, an offsetting asset. And it’s usually considered as cash. So let’s say that someone pays you $100,000, and you have to do $50,000 worth of work. You haven’t realized that $50,000 worth of revenue. And likewise, there is a liability associated with it. And there should be an offsetting asset registered on your balance sheet. Sometimes services companies get a little sideways on that they don’t appropriately accommodate for those deposits, those customer deposits as a liability. Hopefully that adds a little bit of clarity Rhianna kind of what is debt and what is cash.


Ryan Barnett  03:40

That’s a great start, it helps to just frame it up on on the trade payables and the your prepaids. And then the liabilities associated with it, weaker cash free debt free, it often seems like it comes from financial buyers. Is there a reason why a financial buyer would prefer cash free debt free? Or is there advantages to a buyer for it? Or differently? Is there disadvantages to a seller? There other scenarios in which you would not want to consider cash free debt free?


Mike Harvath  04:12

Yeah, so that’s a good question. Right? And I would say that, yes, there is, you know, if you think about in a cash free debt free situation, you’re turning over all of your accounts receivable on the asset side of your balance sheet, to a buyer. And if you’re a relatively fast growth tech services company, tech enabled services company, you’re constantly you know, signing up new engagements, or new clients or invoicing them, and you’re doing so at an ever increasing rate month over month. And if you’re doing that, it’s likely that you have a fair amount sitting out in AR on the asset side of your balance sheet. Now, if you do a good job of collecting your cash and keeping your payables in order, you are in a situation where maybe leaving some money on the table there as a seller, and I think every situation is different. So I don’t want to make this sound like an absolute, it is not, you know, you’d have to, you know, have a financial advisor or an m&a advisor weigh in on the situation for you, specifically. But in general, if you’re a fast growth tech services company, cash free debt free isn’t as necessarily as good for you as having more of what I would call a coverage ratio approach. If you think about a one to one coverage ratio, your assets equal your liabilities, that is turning over what we call Net Zero working capital balance sheet to a buyer. And in theory, if you have appropriate days of sales outstanding or AR Aging, you should be able to collect, the buyer should be able to collect enough cash in the next 30 days to pay the liabilities that need to be paid in the next 30 days, by taking a coverage ratio approach. Now some buyers recover require a coverage ratio of more than what we’ll call Net Zero working capital or coverage ratio one to one or assets equal liabilities, some require a little extra on the asset side to accommodate for maybe some slow pay client, particularly if you have AR that’s aging that’s longer than 30 days, they may require and justifiably so, having a coverage ratio of 1.1 to one or 1.2 to one, in order to make sure that there’ll be enough assets to cover off the liability side of the balance sheet. Now in that situation that I’ve just painted, if, for example, you were to have just sold a big engagement and invoiced it, you wouldn’t be able to recover that money, either in the true up to net out working capital, or at the time to close depending on your buyer. So we’re in a cash free debt free situation, you will be foregoing that asset that you had just invoiced.


Ryan Barnett  07:13

In that case, if you have a large deal, you’re almost better off not taking the deal, or taking the sale of that project.


Mike Harvath  07:20

No, I mean, you certainly should not interrupt your business, we often I’ve said to not interrupt your business or run it as if you’re going to sell it, I’m just saying that you may be leaving money on the table in that situation. If you take cash free debt free, and you just you know you’re growing quickly, or you just closed a big engagement, a, what we call coverage ratio approach are one where you focus on having a balance sheet that’s in balance at the time of close would allow you to not leave the value of those assets on the balance sheet when you transferred it. So it’s just a situational thing. Now maybe you haven’t done that, right? Maybe you’re that’s why we say every situation is different. Kashmir definitely can work for many people. And it isn’t a negotiation. And I think what you need to know all these concepts are swirling around how much working capital is being left in the business to operate the buyer, you are selling a business as a going concern. And when you sell a business as a going concern, it needs to have enough working capital to operate post close, you can’t strip all the assets out of the business, cash or otherwise, because then the definition doesn’t hold water, you’re not selling it the only concern you’re sending selling an undercapitalized business. So having an advisor that can advise you as to whether or not a cash free debt free deal is fair to you or not, or can take on the negotiation around a more neutral balance sheet approach to negotiate as close to net zero working capital or a working capital ratio of one or one to one would be important, because these concepts are complex. And they’re always ones that involve negotiations.


Matt Lockhart  09:12

I think to kind of raise it up into culture, strategy, financial trust. So in essence, and we like to start this discussion, you know, pretty early, it’s like, Hey, guys, let’s make sure, you know, from a common sense perspective, that a seller gets credit for everything that they do up until the day of close, and then the buyer gets credit for everything right. And so in that principle, it’s like well, no, I in your example of I closed a massive deal, right? Well, I’m gonna need to get credit for that as a seller and to your point. Sure, it’s a negotiation how much credit how much guarantee Is that revenue that’s gonna come through? All of those things need to be taken into account. But if all of a sudden the buyers like no, I demand this and we sat, right, it’s like, well, you’re not negotiating in good faith. And so I think that that’s also needs to kind of get brought into the discussion because if, if that’s the case, boy, we’re running up against that this just may not be a good fit.


Mike Harvath  10:25

Yeah, I guess I would also add that you bring up a good point, there’s lots of ways to handle this discussion and negotiation depending on your situation, whether it changes purchase price, either way, it may impact purchase price, for example, if you have debt on your balance sheet, and you haven’t extinguished that debt free clothes, there is going to be a reduction in purchase price no matter what, whether you’re working through a cash free debt free transaction, or whether you’re working on a coverage ratio type model. For example, if you don’t have enough assets to cover the debt on your balance sheet, then you’re gonna have a reduction in purchase price to cover that. That’s typically what happens in a clause. Likewise, if you have excessive assets, whether they be in cash, or AR that you’ve accumulated in the business, and yet you don’t really have any liabilities. As an owner of the business, you have the right to harvest all of that. And to be able to take it one way or another. I mean, we see from time to time business owners that run their business with access working capital, well, I should say more often than not, we do because they don’t want to get into their credit facilities, a lot of business owners might cover a coverage ratio of two to one or three to one, where their assets are twice as much as their liabilities are three times as much as their liabilities. And usually that’s sitting in cash so that they can be flexible and nimble around running the business and making sure that they can meet their obligations without having to get into any credit lines of credit facilities. And in that case, that excess acid or that additional working capital should be harvested is the only time Franklin that business owners are typically comfortable enough to harvest their excess working capital is when they sell. Because oftentimes, they get in a mode that says, well, we just always run with a two to one ratio, or three to one ratio. And that’s how we’ve done it since inception. That’s what we’re comfortable, we’re conservative, we want to run our business in a way that we can be aware of any potential unforeseen issues, you know, things like COVID or pandemics or you know, the the are able to weather the storms of a, maybe a drought and do customer acquisition or whatever it might be by being over capitalized, if you will. And so the time to harvest it is when you sell, and it’s just almost the only time you can do so. But I’m just telling you that that night kind of cuts both ways. If you have too much liability and your balance sheet that’s quote unquote, underwater, you may have heard that term. And it’s up to you to shore up those liabilities prior to close. And likewise, if you’re over capitalized, you have the ability to harvest cash and excess assets at the time of loss.


Ryan Barnett  13:20

Like do some companies use the historical cash on the books as a leverage point for negotiations? So if someone has a two to two to one or three to one coverage ratio, is it often for a buyer to come back and say, Well, you’ve been running the business this is so you must require it? Is that a sticking point when it comes down to harvesting working capital?


Mike Harvath  13:42

Yeah, I mean, it’s something a financial buyer always tries to do, and I think is inappropriate for them to do. So. They say that? Well, because you have historically been running it this way, you must need it. That isn’t the case, generally. And you should know that, right? You could run the business in the purest sense, you could run the business with, you know, current assets equaling current liabilities and technically have enough working capital to run it and meet the definition of a going concern. That may mean that you’re short on cash from time to time, where you can either get in or out of a credit facility and there’s certainly plenty of people that run their business pretty close to working capital ratio of one to one. So there is a bit of a negotiation this is you’re kind of getting into VLANs so the negotiation of how much working capital is enough, right? How much is enough to cover the liabilities and any contingencies in a generally is never based or shouldn’t be based I should say, historically, how much asset you have on the books. It should be really focused on how much is actually required. And you know, our financial team here at revenue rocket can do you know, meaningful testing about what is actually required. And I think any credible buyer will be able to do the same for versus what historically has been on the balance sheet from an asset perspective, and then you can begin to focus on that number.


Matt Lockhart  15:09

Jumping in Mike on that one is some owners, they feel better when they’ve got an excess amount of cash that’s left in the business. And it’s like, well, you know, I’ve got it for a rainy, and we often guide to say, we’ll look at your pastures, like, you don’t need that much cash in the business.


Mike Harvath  15:31

Yeah, I would say that most entrepreneurs, because they’ve, you know, bootstrapped these companies and built them by taking some risks are, you know, wanting to have a little extra cash to just sleep better at night, you know, they didn’t want to have any speed bumps that they’re gonna hit, caused them to tip over the capitalization of the business. And I think, you know, in many ways that’s prudent. It’s not necessarily needed. But it’s prudent. And I often say that, if it’s, if it’s the elixir that helps you sleep well at night, then you know, knock yourself out. But you do have the ability to harvest that money, it is your money. And we oftentimes will advise that people, you know, reduce their asset holdings on the balance sheet, prior to a transaction or in preparation for a transaction to sort of mitigate or neuter that negotiation argument from a buyer that says, Well, you’ve had a coverage ratio three to one for the last three years. And as a result, you must need a business. So that’s what we want. It’s not, you know, if you have a smart advisor, they’re not going to let that happen. And because it just that argument is just not very strong.


Ryan Barnett  16:49

Matt you’ve done a number of these negotiations lately. And when you get to work in capital, and you get to the terms, cash free debt free for both buyers and sellers, it can often be a relatively contentious, I think you’re taking ash that an owner sees right in front of them. And it’s very kind of hard to work through. What advice can you give to buyers and sellers to work through and come to come to a place that’s better for the best place for everyone at the end?


Matt Lockhart  17:20

I think don’t kick the can down the road.


Mike Harvath  17:25

What Matt means by don’t kick the can down the road: sometimes you’ll hear people say, well, we can manage that in the true up, right? Oftentimes, there’s a 90 day or 180 Day true up for working capital, because you don’t know what the expenses of the business are going to be very specifically. And likewise, you may not know, you know, what the assets are at the day of clothes, right? You may have gotten a check. And let’s say it wasn’t, it came in the day before close. And so you know, you didn’t get a deposit until the day after close, you know, it doesn’t account or whatever. So there’s oftentimes a true up, because some of the bills with a business may come after clause and cover falls apart when you own the business and when the new owner on the business. So sometimes you’ll hear a buyer or seller, if they get to an impasse. And then negotiation say, well, we’ll manage that and the true. And they’ll never really come to a reconciliation, how to solve and define what’s in and out on cash free debt free, or what’s in and out on a coverage ratio negotiation. And we think that’s a mistake, there needs to be a strong man attached to the definitive agreement as an exhibit, there needs to be clarity about what’s in and out. And there needs to be clarity about what unforeseen expenses, or assets may be coming, that could impact the truth. And the more time you take to get that right before it close, the easier that true up negotiation is going to be. If you’re just attempting to kick the can down the road to the true up, and you have material issues to negotiate. But you’re just trying to get closed on both sides. Because you’re, you know, feeling tired and you want to get across the finish line. That is a mistake and ultimately is going to create some heartburn when you get to the reconciliation negotiation.


Matt Lockhart  19:23

Yeah, thanks, Mike. And I think that even starting earlier in the context of saying hey, this is how we define cash free debt free and then gaining agreement as early as possible in terms of the framework at which you will drive out what adequate working capital needs are right. And so the earlier that you can gain agreement by both parties, that that there is a method that is logical, and it makes sense that the better Right, so that near the end of due diligence and near the close of the transaction, there’s no surprises. And I think that that also really holds true and plays into, you know, what you’re talking about in terms of what a definition of a true up is. Right? It’s, again, it’s make it as logical as possible, and do it as early as you can.


Ryan Barnett  20:29

Yes, that’s great advice, Matt. Appreciate it. And, Mike, appreciate your insights here on this topic. That’s all the questions I had for you today. I’ll turn it back over to Matt and Mike, for any closing thoughts.


Mike Harvath  20:43

Thanks, Ryan. Yeah, I think the key here is, if this is not a strong business case, for you know, leaning on your, your accountant, or m&a advisor to help you determine what is a fair amount of working capital and millennials, these topics are fairly complex for most business owners, and do require some outside expertise and analysis of your financials. And certainly, you’re going to want to be leaning on your advisors to make sure that these numbers are negotiated fairly. And that you’re in a position to make sure that that both sides come out, sort of on top, if you will, of this negotiation, it is a give and take, it’s important to know that, you know, let’s typically good for one side, maybe not so good for the other and vice versa. So you need to walk a mile in the shoes of the other side. And understand as they acquire your business that they’re going to run right that they need to be able to have adequate working capital and managing run it just as you would want that if you were buying the business, so that I will tie a ribbon on it for this week’s podcast. We’re here to help you get to the next level. And I would encourage you to drop us a note at info at revenue rocket. If you’d like to learn more stop by our website revenue rocket.com. So take care make it a great week, and we hope you tune in next time