(1) How Does CFDF Affect The Economics and Pricing of a Deal?
The pricing of most M&A deals is mainly based on an Earnings Before Interests, Taxes, Depreciation and Amortisation (“EBITDA”), or earnings multiple.
Such deals are usually negotiated on a Cash-Free Debt-Free (“CFDF”) basis, where the Seller retains all cash-like items, and pay off all debt-like items in the Target company, upon completion of the M&A transaction.
(2) Differences in Buyer’s and Seller’s Perspectives For Cash-Like and Debt-Like Items
When it comes to determining what qualifies as cash-like and debt-like items in CFDF deals, there is no universally agreed-upon standard definition. Thus, the classification of these items can be constantly challenged by both Buyer and Seller as they have very different perspectives and arguments on what constitutes net debt (i.e. cash less debt).
Sellers in CFDF deals have a vested interest in maximising the amount paid by Buyers. Thus, from a Seller’s perspective, they prefer to have a narrower definition of debt, and a broader definition of cash. By narrowing the definition of debt, Sellers aim to exclude as many liabilities as possible to be categorised as debt-like items, reducing the potential downwards purchase price adjustment. On the other hand, a wider definition of cash allows the Seller to include various forms of cash-like asset in the purchase price adjustment. Hence, enabling the Seller to maximise the amount to be received from the Buyer.
On the contrary, Buyers in CFDF deals seek to minimise any upwards purchase price adjustment due to the Seller. Buyers are likely to favour a broader definition of debt and a narrower definition of what constitutes cash. By having a broader definition of debt, Buyers seek to include as many liabilities in the debt-like categorisation, increasing the potential downwards purchase price adjustment. On the other hand, a narrower definition of cash allows the Buyer to exclude potential cash-like assets in the purchase price adjustment. This enables the Buyer to minimise the amount due to the Seller upon completion of the transaction.
(3) Examples of Cash-Like Items
The categorization of certain contentious line items that can be further discussed includes:
- Restricted Cash Balances: These cash balances held in foreign jurisdiction have strict capital control rules imposed. As such, the movement of cash in and out of the country may be heavily regulated or limited. The Buyer may argue for such balances to be excluded in the cash-like categorization if the Target company has dismal business activities in that country, as it has little or no use of the cash balance.
- Deposits: Rental deposits can be argued to be cash-like in nature by the Seller as the Buyer will get the rental deposit back upon expiration of the lease.
- Examples include prepayment for rental or insurance. The Seller may view this as cash-like in nature as there is a future benefit to be received by the Buyer and the costs for this was borne by the Seller.
Should these items be categorized as cash-like and not working capital in nature, the Buyer will need to prepare for an upwards adjustment to the purchase price.
(4) Examples of Debt-Like Items
Analysis for potential debt-like line items can fall into two main categories: (1) interest bearing debt; and (2) non-interest-bearing obligations.
Some examples include:
- Customer Deposits/ Deferred Revenue: Buyer may argue for these balances to be classified as debt-like as the Buyer will need to provide services to the customer but Seller has already received the economic benefits associated with these proceeds.
- Provision for Reinstatement Costs, Deferred Tax Liabilities, Provision for Taxes, and Off-Balance Sheet Items: The Buyer may have concerns about certain future costs that could arise in the ordinary course of business, and as such may wish for the Seller to bear a portion of these costs.
- Maintenance Capital Expenditure: Should the Seller have incurred less than required for maintenance capital expenditure to cost save, the Buyer may wish for the Seller to share some of these required maintenance capital expenditures.
Should these items be categorized as debt-like and not working capital in nature, there will be a downwards adjustment to purchase price for the Buyer.
(5) Agreement of Cash-Like and Debt-Like Items
Given the contentious nature of cash-like and debt-like items, the categorisation of balance sheet items should be proposed and agreed upon as early as possible in the M&A process, ideally in the post financial due diligence phase, and before drafting of the SPA.
It is advisable to perform a detailed balance sheet categorization, ideally at the trial balance level. This allows for a comprehensive examination of individual accounts that can help to facilitate a more accurate classification of cash-like and debt-like items.
Most importantly, this can prevent potential disputes or disagreements surrounding the classification of cash and debt-like items which may arise upon completion of the transaction, months after signing of the SPA.
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