The concept of a “cash free/debt free” deal is very common in M&A transactions, but what does it actually mean?

On the face of it, it is a fairly simple concept. The buyer purchases the business and its assets at completion, and the seller is left with the cash and debt. The purchase price will therefore be the agreed price (excluding cash and debt) + cash and cash equivalents – debt.

Although the buyer and seller may understand the basic concept, it is common for neither to fully appreciate, at the time the deal is struck, what the actual financial position will be at completion of the sale and purchase.

This is because the concept of “cash free/debt free” can work in a number of different ways which may have widely varying outcomes. This is principally because the concept has to be applied to a company, which is by its nature an entity into which money flows in and out, often unpredictably.

Not surprisingly the detail is crucial when constructing the most appropriate legal terms to reflect the intentions and understanding of the parties.

To ensure that the buyer and seller are in the position they have agreed and expect, the drafting needs to be clear and precise. It would seem to be a simple task to draft appropriate definitions but this is not always the case. The principal reason is that there are no generally accepted definitions of “cash” and “debt”.

This exercise of drafting appropriate provisions is one which will require careful consideration and negotiation by the lawyer, with the assistance of an accountant and financial adviser. It is important that all advisers are experienced in M&A transactions and understand the issues involved.

Only by looking at each company on an individual basis and on an item by item basis will the parties be able to sensibly agree what constitutes “cash” and “debt” for a particular business.

What should fall within debt/liabilities for the purpose of the debt free element?

There should be some straightforward elements to this. In almost all circumstances, shareholder loans, long term debt, bank debt, unpaid dividends, overdraft facilities and cheques drawn but not paid will be treated as debt and “stripped out” of the business for the purpose of calculating the purchase price. Trading debts are usually excluded and intra-group debts are usually dealt with before completion. Other potential debt categories, for example tax liabilities, letters of credit and staff bonuses are likely to be the subject of negotiation.

What should fall within cash (or cash equivalents) for the purpose of the cash element?

When defining “cash”, cash at bank and in hand/petty cash and credit card payments in transit are invariably included. Book debts are not usually treated as cash until they have been paid and converted into cash and the potential movement in this area will need careful consideration. The treatment of other types of “cash”, such as short term investments, restricted cash (rent deposit, surety accounts), foreign cash (where there may be issues with repatriation), and escrow cash balances are likely to depend on the specific circumstances and what can be negotiated.

When is the most appropriate time to agree the finer detail of how the cash free/debt free part of the transaction will work?
This can be done at heads of terms stage. This would avoid the need for more detailed negotiation later, but often the parties will not wish to go into such precise detail at this relatively early stage. It is more common for this exercise to be undertaken as part of the negotiation of the share purchase agreement.

In terms of the practical mechanics of settling the final completion price, an estimate of the anticipated cash and debt position is usually made shortly before completion, and this is part of the determination of the money that passes on completion. This is then followed after completion by the preparation of accounts showing the actual position as at completion, upon which appropriate adjustments are made to the amounts which were paid at completion.

Finally, an alternative approach may be to consider a “locked box” mechanism whereby the price is fixed at a certain date by reference to the financial position of the business as at that date, and the seller then covenants to run the business in a certain way between the locked box date and completion. The risk of what happens to debt and cash in the interim period lies with the buyer.

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