Understanding Debt-Like Items and Their Cash Flow Impact
Contributors
As mergers and acquisitions begin to pick back up, buyers and sellers should not lose sight of potential debt-like items that can significantly impact net proceeds from a sale and post-close cash flows.
What Is a Debt-Like Item?
Transactions are typically structured on a cash-free and debt-free basis, meaning the seller pays off all outstanding bank debt and retains any remaining cash at close. Therefore, the proceeds from a sale increase by the amount of cash the seller is retaining and decrease dollar-for-dollar by the amount of unsettled debt. While we often consider debt to be the principal and accrued interest associated with interest-bearing instruments (mortgages, lines of credit, bonds, notes, etc.), other liabilities, both on and off the balance sheet, can have characteristics similar to debt or relate to non-operational items of the acquired business. Buyers and sellers should not ignore these debt-like items when negotiating a potential transaction because they have real economic implications.
Potential Debt-Like Items
Aged Accounts Payable: Payables associated with vendor disputes or extended payment terms; Depending on the payable’s age, the buyer may be responsible for payment of inventory that has been sold or a service that has been rendered prior to closing, which may not be considered ordinary course.
Accrued Bonuses and Commissions: Amounts due to employees associated with the business’ performance; for annual and quarterly plans, a significant cash payment may be required post-closing per compensation plans and to ensure employee retention.
Earned but Unpaid PTO: Amounts that may be due to employees upon termination; if the business does not have a “use it or lose it” policy associated with paid time off, these post-close cash flows could be significant for tenured employees.
Accrued Severance: Payments due to former employees where the related expense is often treated as an addback to EBITDA.
Customer Deposits and Deferred Revenue: Cash received upfront to provide a product or service in the future; because the seller walks away with cash on hand, the buyer will be required to bear the cost associated with providing the associated products or services. Deferred revenue often requires close attention and may also have post-closing tax implications.
Accrued Legal Settlements: Obligations associated with ongoing or settled litigation resulting from activities occurring prior to the change in ownership where, in addition to a post-close cash flow impact, the related expense is often treated as an addback to EBITDA.
Earnout Obligations: The deferred purchase price associated with a prior acquisition; the terms of the prior acquisition may require future non-operational payments to a third party. Buyers should understand the terms of the prior acquisition as the balance sheet may not fully reflect the final obligation.
The treatment of these and other potential debt-like items not listed above will depend on the facts and circumstances associated with the liability. Will the buyer be required to fund these obligations post-closing? Did these liabilities arise from non-recurring or non-operational events? Has the seller collected cash upfront for a service to be performed post-closing? Is there a corresponding adjustment to EBITDA? These questions should be vetted during due diligence to determine whether these liabilities are debt-like or more accurately reflect operational working capital liabilities.
Considerations for Buyers and Sellers
Debt-like items vary from business to business. It is unlikely such items are identified and negotiated in a letter of intent (LOI); rather, these items are typically identified during the post-LOI due diligence process. Because there is not a one-size-fits-all definition of debt in the context of M&A, debt-like items identified during due diligence will need to be negotiated and then ultimately reflected in the defined terms of the purchase agreement.
Buyers should ensure their pre-acquisition due diligence process identifies debt-like items and adequately addresses them in the purchase agreement and valuation model. Not doing so can result in having to unknowingly fund non-operational obligations post-closing. When you cannot quantify liabilities, the buyer should ensure they are properly indemnified or have a portion of the purchase price held in escrow to cover these potential exposures.
Sellers should also identify debt-like items when preparing for a sale. Doing so will better prepare the seller for negotiations and avoid surprises down the road that may alter proceeds from the sale. Once you identify debt-like items, the seller may be able to settle such liabilities before buyer due diligence begins or have a basis for a more aggressive stance when negotiating other terms of the transaction.
Dealmaking is an art, and buyers and sellers who arm themselves with adequate information have the means to negotiate better deal terms and maximize deal value.
