"Cash Free, Debt Free" vs. Working Capital Allocation
May 04, 2024
by a searcher from Brigham Young University in Kahului, HI, USA
Can anyone share any insight into why there is such regular confusion in the M&A and Broker community related to "Cash Free, Debt Free" acquisitions and whether they include any allocation for working capital?
It is tempting for me to try to pin it on SMB arena and asset purchases vs. private equity and stock purchases, but in my experience it isn't that simple. I keep running to people at all levels that play it both ways. One of the truly confusing things about it is that most people have only ever done it one way or the other and are shocked/defensive that it is even a point of question.
Maybe I'm the only one...
from The University of Chicago in Chicago, IL, USA
Cash Free Debt Free (CFDF) balance sheet excludes cash, debt and debt-like liabilities. Enterprise Value or the Price P includes any and all assets required to generate the profit, meaning buyer gets the CFDF balance sheet for the Price.
Why there is confusion?
1) Some derive price P using multiples from databases that exclude Working Capital. If so, WC is in addition to P. Buyers often wind-up over-paying using this approach if business is WC intensive.
2) Ideally P should be derived using DCF. In this case, P includes WC. If you exclude WC in the financial model, you are going to run into serious cash flow problem while growing and if not growing, IRR will be lower than expected.
3) How much WC should be included in P? Typically, WC peg is 12 months average. This requires work and good record. At closing, the actual transaction price is adjusted for difference between actual WC and WC peg. Quantifying WC peg and crafting agreement for closing adjustment, requires work and skill. A short-cut is to ignore WC from P and promote that as the standard.
4) Assume P includes WC (A/R, Inventory, A/P) as it should. Also assume total P is financed. Even in this situation buyers often ask, and banks provide "additional capital (X)"; they call this X Working capital. Talk about confusion on WC
5) What is CFDF? What is WC peg? Have taught this for years in 4hr, 8-hr class, and have helped fix many broken deals,
from University of Pennsylvania in Charlotte, NC, USA
But there are many exceptions or different definitions of these terms, including the word cash (e.g. cash-in-transit.) When you're talking to sellers, you can completely avoid using these terms and simply say what they mean - we intend to buy the company's assets including normal course a/r and inventory but excluding cash, and we will assume certain liabilities including normal course a/p and accrued expenses but excluding funded debt obligations, for $xxM. At least this is a clear starting point for discussions.