Most M&A transactions are structured on a ‘cash-free, debt-free’ basis. Cash is relatively straightforward, with some exceptions, for example unpresented and inbound cheques and cash that may be working capital, e.g. cash floats at retail locations.
Debt however can take many forms and it can be cleared at transaction close or directly reduce the purchase price. The consequence of not adequately identifying debt or ’debt-like’ items ranges from cash flow holes shortly after completion and/or the need to approach acquisition financiers ’cap in hand’ for more funds.
In addition to items that are clearly debt, such as external bank funding and related party borrowings, the following items can be ’debt-like’ items in M&A:
When a business has unearned income, cash will be received up front and goods/services will follow thereafter. If the vendor removes cash at transaction close, the new buyer will be left to provide the goods/services and recognise the revenue, but not receive the most important thing, the cash! Unearned income can therefore be treated as a debt-like item, noting the unearned income can be adjusted to reflect the costs to provide the goods/services.
A business has many statutory liabilities, such as GST, superannuation, payroll tax and FBT, which are considered working capital, unless they are overdue, in which case they may be considered debt-like. Income tax should be considered debt-like as it relates to the business’ capital structure rather than its operations or employees. Again, if it is overdue, it should be considered debt-like.
Further to the above, if a business has trade creditors that are well overdue, these could be considered debt-like as an acquirer will likely need to make a one-off investment to bring trade creditors back to normal terms, as well as considering the impact this has had on the relationship with the supplier.
Letters of credit (LCs) and bank guarantees
These items are provided by financiers, indicating they are debt-like. LCs are often recorded in creditors (or not at all) and reduce a company’s working capital facility. Bank guarantees post transaction may be required to be replaced by cash, but if not, still have a cost payable to a financier. Both items have strong debt-like characteristics, but convincing a seller that these are debt will depend on the rationale for using these instruments in the first place.