When we are looking to acquire a business, we price it on a cash-free, debt-free basis. The reasons for doing this make for a fair transaction for everyone involved.
For many business owners, the sale of your business will be the first time you come across the concept of pricing a business on a “cash-free, debt-free basis.” Given the stakes involved, we want to help you understand as much as possible about:
Then we’ll share some examples of how it might work
A “cash-free, debt-free basis” in the context of an acquisition means the seller keeps all cash and is responsible for paying off debts when the sale closes. This means the buyer takes over the business with no excess cash or debt obligations with the seller.
At a high level, it’s fair and simple in that it allows the parties to agree on the value of the underlying operating business and then deal with the assets and liabilities somewhat separately.
The value of the underlying operating business refers to the revenue, profits and cashflow that the business generates from its operations.
For example, an online shop selling pens has a core operating business in getting pens manufactured then selling them. The operations cover marketing the pens, designing pens, getting the pens manufactured and then selling them. The operations don’t include, for instance, the interest they earn on the cash they have in their bank account.
The operating business can be valued on the profit, revenue or other strategic benefits it is expected to create for its owners.
Another way of thinking about a cash-free, debt-free basis is that you value the operating business in isolation. As the selling owner, you get paid that value in isolation. Then you get another payment or reimbursement of net cash and liabilities from your period of ownership. The buyer gets to start with a clean slate of just the operating business, free to build their own cash or liabilities.
To help illustrate the point, let’s explore some simple examples that illustrate common situations.
A business is valued at being worth $8m on a cash-free, debt-free basis.
The business has no debt, all its taxes are paid and the owners have done a good job of saving for a rainy day and they have $1m in their bank account more than the business needs for working capital.
At the time of sale, the owners get to keep the surplus cash of $1m and the buyer will pay them $8m for the business. The owners receive $9m in proceeds from the transaction.
The cash was earned by the owners, under their ownership. It’s pretty fair to say they are entitled to it.
A business is valued at being worth $8m on a cash-free, debt-free basis.
The business has unpaid tax debts of $200,000. There isn’t any excess cash beyond working capital needs and no other liabilities.
At the time of sale, the owners can either pay the tax debt or it will be reduced from the purchase price (if the buyer has to deal with it). Assuming the owners don’t pay it, then the buyer will reduce this from the purchase price as it has to deal with a debt incurred under the old owners watch.
This is fair because the old owners received the benefit of the liability as they had the benefit of ownership of the company and, usually, paid cash out to themselves, instead of paying down the debt. So they need to deal with the liability.
The cash-free, debt-free basis for determining a purchase price works because it isolates the value of the core operating business.
Once you’ve isolated the value of the core operating business you gain some additional benefits as a seller or buyer:
To help illustrate why the cash-free, debt free basis helps, lets do a comparison of two similar businesses. In fact, let’s say, for arguments sake, both businesses are exactly the same in how they operate. They have the same revenue growth, same operating margins and same level of profitability.
Their operating businesses are valued at $8m. Given their performance is so similar, it wouldn’t be reasonable to value the operating businesses differently.
However, one business, FrugalCo, saved its cash and kept it on the balance sheet. The other business, DividendCo paid dividends for most of the cash each quarter.
It’s fairly reasonable to say FrugalCo should get the value of the operating business, plus the extra cash they saved. While DividendCo has already taken the cash out so should just be paid the value of the business.
The short answer is it’s unlikely you will be able to negotiate not to use it as the basis of acquisition if the acquirer or investor has used it. Most sophisticated investors will require that it is used, so trying to fight it is fighting against the investors’ system which is one negotiation you’re unlikely to win.
The better answer is to work with it. The way you work with it is to go through the details of what is being considered as cash, assets, working capital and debt.
Your options are to:
