Understanding Cash-Free Debt-Free (CFDF) M&A

Most acquisitions between SMEs involve some element of the cash-free debt-free (CFDF) arrangement.

As the name suggests, this means that the buyer acquires the equity of the business only (and not its debt or equity), demanding that the owner of the business settle any outstanding debts and at the same time, enabling them to legally take the business’s outstanding cash balance before the transaction closes.

In this article, we at DealRoom look at some of the aspects of cash-free debt-free transactions, things that should be looked out for in these transactions, and how the terminology can be misleading when taken at face value.

The Cash-Free Debt-Free Rationale

The main rationale for cash-free debt-free deals is that the buyer wants to acquire a company and its future cash flows.

It wants to avoid the excess ‘baggage’ that comes with acquiring anything outside of these parameters.

For example, take cases where the company has undertaken complex debt agreements, in which the shareholders of the business have used personal collateral to guarantee the debt.

This, along with any other covenants which were made at the time of the loan, would have to be reorganized if an acquirer of the business took on the debt.

On the cash side, the name cash-free is something of a misnomer (more of which below). What’s actually happening is the firm is being acquired without any excess cash.

In practice, this means that the cash value on the balance sheet is often added to the acquisition price to compensate the buyer for it, effectively allowing them to ‘take it from the balance sheet.’

This is just one of the many technicalities of cash-free debt-free which means the expression shouldn’t be taken too literally.

Which brings us to...

Defining Cash Items

What is cash?

At first glance, the answer may appear obvious, but recall that a standard item which appears on the assets section of any balance sheet is ‘cash equivalents’, and the line between working capital and cash is also quite blurred.

It’s therefore not unusual for some room back-and-forth over what defines cash in an M&A transaction, giving rise to ‘cash-like’ assets.

Cash in this context comes down to what the buyer and seller agrees constitutes working capital - the amount of cash that allows the company to change hands without any need for accessing a credit facility (i.e. enough to “carry operations”).

The buyer will understandably push for more cash here, for insurance purposes as much as anything else, while the seller will inevitably want to obtain as much cash from the transaction as possible and play down the working capital requirements.

Defining Debt Items

The definition of debt can be similarly difficult to pin down, which is where we run into the notion of debt-like items: strictly speaking, these aren’t debt (i.e. they’re not loans owed to a third party) but they do have all of the characteristics of debt - the company will have to pay them, just as if they were a loan.

Most of these debt-like items are liabilities and constitute a second area of potential dispute between the buyer and seller.

For example, nobody can forecast with certainty the pension liability of a defined benefits pension plan.

Thus, the seller looks to talk down the size of the liability, while the buyer, knowing that he or she will have to pay the future pension liabilities will play them up.

Other areas where a dispute may arise regarding debt-like liabilities include warranty claims, accrued employee bonuses (something which even otherwise excellent due diligence processes tend to overlook), a letter of credit, pending legal settlements and tax liabilities.

It’s not difficult to see how a process whose aim was ostensibly to simplify the transaction can quickly become quite complex, but most of these issues are relatively minor for the most SMEs.

Conclusion

As this article has outlined, cash-free debt-free sounds straightforward but quickly runs into complexities and different interpretations.

Depending on how many day-to-day business transactions the selling company has in a typical quarter, the due diligence for cash-free debt-free can become extremely time-consuming.

However, assuming goodwill on the part of both sides and a willingness to get the deal done, cash-free debt-free can become a formality.

The Letter of Intent (LOI) for the transaction can even be drafted to cater for any unexpected cash-like or debt-like items that didn’t show up in CFDF.

Both sides then find a middle ground that they’re satisfied with and one that reflects a fair value for the company being acquired.

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