Unlocking Value with Net Debt and Working Capital Adjustments in M&A
In most M&A transactions, buyers and sellers agree on a cash-free, debt-free valuation, excluding the company’s cash holdings and debt from the purchase price. However, the real value lies in understanding the nuances of net debt and working capital adjustments. A well-prepared analysis can uncover hidden value, leading to significant savings or increased value for both buyers and sellers. This article explores how the net debt and net cash adjustments and working capital adjustments work and why they are critical to a successful transaction.
1. Cash-Free, Debt-Free Valuation: The Basics
A cash-free, debt-free valuation determines the enterprise value (EV) of a company, excluding cash and debt. The net cash adjustment (or net debt adjustment) —cash minus debt—is added or deducted from the purchase price.
Example: considering Company A and Company B, with both a $50M EV, but with different net cash profiles:
- Company A holds $10M in cash, and has no debt;
- Company B holds no cash, and has $15M in debt
=> Upon acquiring the shares of Company A, the buyer gains access to its $10M cash reserves. In contrast, acquiring Company B requires the buyer to assume and repay $15M in debt. Therefore, the enterprise value (EV) must be adjusted to reflect each company’s net cash position. As a result, Company A’s adjusted value becomes $60M ($50M + $10M cash), while Company B’s adjusted value drops to $35M ($50M – $15M debt).
This adjustment ensures that buyers benefit from any cash held by the company while accounting for the debt they must repay.
2. Identifying Debt-Like and Cash-Like Items: A (Non-Exhaustive) Checklist
While the cash-free, debt-free concept seems straightforward, net cash adjustments often involve more than just subtracting loans from bank balances. Debt-like liabilities that must be repaid and cash-like assets that may not be fully accessible must be considered. Identifying these items can save or generate millions of dollars for both buyers and sellers. Below is a list of some of the most common items to consider when identifying debt-like and cash-like components:
- Contingent Liabilities: Earn-outs or warranties from previous acquisitions.
- Shareholder Loans: Should ideally be settled at or before the transaction’s closing.
- Dividends Payable: Unpaid dividends approved before closing count as debt.
- Litigations or Unpaid Taxes: Expected liabilities for lawsuits or tax obligations may be in certain circumstances considered as debt-like.
- Accrued Interest: Interest that accumulates on loans up to the closing date.
- Transaction Expenses: Unpaid costs related to the M&A process.
- Trapped Cash: Cash restricted by regulatory requirements, covenants, or foreign exchange controls. You may also need to factor in tax costs if repatriating cash from foreign subsidiaries.
- Deposits and Guarantees: Security deposits (e.g., for rent) may be considered cash-like under certain conditions.
- Fair Value Adjustments: fair value of derivatives or financial instruments (such as interest rate or currency swaps, forward contracts, etc.) may impact cash, even if not reflected on the balance sheet.
These items are often unearthed during due diligence by third-party advisors. If the seller hasn’t conducted a vendor due diligence, M&A advisors like Maelex play a crucial role in identifying cash-like and debt-like items to maximize transaction value.
3. Working Capital Adjustments: An Often-Overlooked Price Component
Working capital represents the portion of a company’s assets available to cover short-term obligations. It focuses on operational assets, such as receivables and inventory (but excluding cash), minus liabilities like supplier payments and accrued costs.
Beyond net cash adjustments, working capital adjustments ensure that the company operates at a normalized level of working capital post-acquisition. This prevents the buyer from inheriting underfunded operations or unexpected liabilities.
Example:
- Company A operates normally, with $1M in accounts payable.
- Company B delays supplier payments, accumulating $5M in overdue payables.
=> Upon acquisition, the buyer of Company B must cover the $5M overdue payables, which can significantly impact cash flow post-acquisition. Therefore, the share purchase agreement must include a mechanism to adjust the purchase price to account for any deviations from the normalized working capital level of $1M.
To ensure fairness, the purchase price must be adjusted to reflect a normalized working capital level. This requires both parties to agree on what constitutes a normal level, considering factors such as:
- Historical working capital trends (ideally on a monthly basis).
- One-off events that affected past working capital (such as one-off delays in client payments, stretched payables, underaccrued expenses or revenue, change in customers or suppliers payment terms which will affect the level of working capital going forward, unusual sales or expenses which may impact working capital level in a given month, etc.).
- Expected growth or seasonal business fluctuations.
- Certain items reflected as working capital items in the balance sheet may qualify as debt-like or cash-like items, hence should be excluded from working capital.
Most of these working capital adjustments are unearthed through a detailed analysis of historical working capital. Sellers and buyers must prepare ahead of negotiations by analyzing adjusted normalized working capital. Many first-time buyers or sellers overlook this component, but at Maelex, we’ve helped clients save millions by combining thorough analyses with expert negotiation skills.
4. Conclusion: Preparation is Key
In M&A transactions, well-executed net debt and working capital adjustments often determine the success of the deal. At Maelex, we leverage our financial expertise to ensure these adjustments reflect the true value of the transaction.
Need advice on your M&A transaction?
Reach out to us at contact@maelextechnology.com or through our Contact page. We’d be happy to help you unlock the full potential of your deal.
