When selling a business, the receipt of offers is one of the most exciting stages in the process. It is vitally important, however, to fully understand the technical language used in these offers and the implications this will have on the value that the vendor ultimately receives.
This article will walk through the key technical terms used in the vast majority of offers for a business.
Cash-free, debt-free, normalized working capital
Almost any offer letter from a credible acquirer will state that the offer is made on a cash-free, debt-free basis, with a normalised level of working capital.
This is by far the most important definition to understand, given that it can have a significant impact on the cash that the vendor actually receives for their business. For example, in many situations, a price or valuation of £20 million, may only result in cash of £10 million being paid to the vendor due to these adjustments.
Most buyers will have valued a business by applying an earnings multiple to the EBITDA (Earnings before Interest, Tax, Depreciation and Amortisation). The cash, debt and working capital adjustments essentially ensure that the buyer inherits a business which has sufficient funds to continue trading normally, without benefiting from the cash generated prior to the purchase, or being burdened by any third-party debt taken on by the vendor. Whilst the three elements are inherently linked, it’s worth walking through each in turn:
The offer is cash-free in that it excludes the cash sitting on the balance sheet of the business at completion. This is logical as it means that any cash profits generated by the company before the sale are taken by the vendor, rather than being for the benefit of the purchaser.
Similarly, where a business has third-party debts, such as bank loans or corporation tax liabilities, these are deducted from the price paid to the vendor. Again, this is logical as it ensures that the buyer inherits a business that is not burdened with the costs of servicing these external debts.
Normalised working capital
Ensuring that the business has a normal level of working capital at completion allows the buyer to continue trading following the acquisition without having to inject more funds over and above the purchase price. As part of the completion process, a calculation, therefore, needs to be made to assess the level of working capital in the business and compare this to “normal” levels. This is often performed by comparing the levels at completion to the average working capital over the historic period, such as the last 12 months. Where the level of working capital at completion exceeds the normal level, an adjustment is made to pay the excess to the vendor. Conversely, where the working capital at completion is lower than the normal level, an adjustment is made whereby the vendor leaves additional cash in the business to fund the shortfall.
This adjustment protects the buyer against situations where vendors attempt to manipulate the figures prior to completion (for example, by asking all customers to pay early and delaying the payment of creditors to increase the cash in the business). In situations such as this, the adjustment would simply negate the impact of any manipulation and bring the price back to the correct level.
Deferred consideration versus earnouts
Many transactions, particularly in light of COVID-19, will involve an element of the price being paid at a later date. There is an important distinction, however, between the two types of consideration paid after completion.
Firstly, deferred consideration is the most simple in that it involves the payment of additional cash at a defined future date with no conditionality. For a vendor, this is clearly the preferred situation as it provides certainty over the payment of future cash.
The second possibility is the use of an earnout. This differs from deferred consideration, as the payment is not guaranteed and is contingent upon future goals being achieved. These goals are often linked to the financial performance of the business, such as the achievement of a certain level of profitability in the years following completion. Whilst this is a logical and common way of structuring a deal, vendors should be careful to ensure that the legal documentation provides absolute clarity on the way in which the earnout is calculated. Seeking professional advice in this area is therefore highly recommended.
This article was originally published on Eclipse Corporate Finance and has been republished with permission. Any further republishing should only take place where a “Follow” link is provided to the Eclipse Corporate Finance website.