Most offers for private companies are made on a “cash-free, debt-free” basis, assuming a “normal level of working capital”. The phrase appears in almost every set of Heads of Terms, and it is often misunderstood.
Enterprise value and equity value
A buyer’s headline offer is usually an enterprise value: the value of the business’s operations, regardless of how it is funded. What you are actually selling is the shares, and the price for those, the equity value, is the enterprise value adjusted for three things:
- Cash in the business is added, pound for pound.
- Debt, and items treated like debt, is deducted.
- Working capital above or below an agreed normal level is added or deducted.
The logic is simple. A buyer should not pay twice for cash it could withdraw, and should not inherit liabilities that built up while you owned the business.
A worked example
Suppose a buyer agrees an enterprise value of £5.0m. At completion, the business holds £800,000 of cash, has a £300,000 bank loan, £160,000 of debt-like items (corporation tax owed and accrued bonuses), and working capital £100,000 below the agreed normal level.
From enterprise value to the price for the shares
Illustrative example, £m. The scale starts at £4.8m so that the adjustments are visible.
Show as a table
| Step | £m |
|---|---|
| Enterprise value | 5.00 |
| Add: cash | +0.80 |
| Less: bank loan | −0.30 |
| Less: debt-like items | −0.16 |
| Less: working capital shortfall | −0.10 |
| Equity value | 5.24 |
In this example the seller receives £5.24m for the shares, more than the headline figure, because of the cash in the business. Had the company been carrying significant debt, the result would have been lower than the headline.
What counts as debt?
Bank loans, overdrafts and finance leases are straightforward. The negotiation usually centres on “debt-like” items: liabilities that are not borrowings, but which a buyer argues should reduce the price. Common examples include:
- corporation tax relating to the period before completion;
- accrued bonuses, declared but unpaid dividends, and director loans;
- overdue supplier payments, or VAT and PAYE that has been deferred;
- in some sectors, deferred income for work not yet delivered;
- dilapidations on leased premises, and deferred consideration from earlier acquisitions.
Each item should be considered on its merits. A long list of debt-like items can quietly reduce the price by more than a seller expects.
Normal working capital
Working capital, broadly stock and debtors less trade creditors, is what the business needs to operate day to day. The buyer expects to inherit a normal amount of it. If there is less at completion, the price goes down; if there is more, it usually goes up.
The normal figure, often called the target or peg, is typically based on an average over the previous twelve months, which smooths out seasonal swings. How it is calculated is a negotiation in its own right: a difference of a few percentage points can be worth tens of thousands of pounds.
Is all the cash really surplus?
Buyers sometimes argue that part of the cash is needed to operate the business, to cover payroll at the end of the month for example, and should not be paid for separately. Others treat customer deposits held in the bank as not truly belonging to the business. These are legitimate points for negotiation, and much easier to deal with if they have been anticipated.
Completion accounts or locked box?
There are two common ways of fixing the final figures. With completion accounts, the adjustments are calculated from a balance sheet drawn up at completion, and the price is finalised afterwards. With a locked box, the price is fixed by reference to an earlier balance sheet, and the seller undertakes that no value has “leaked” out of the business since that date. Each has advantages, and the right choice depends on the business and the buyer.
Extracting cash before a sale
Surplus cash can be left in the business and paid for through the price, or taken out before completion, for example as a dividend. The tax treatment of each route can differ significantly, so it is important to take specialist tax advice well before a transaction.
In short
- The headline offer is usually an enterprise value, not the price for your shares.
- Cash is added; debt and debt-like items are deducted; working capital is adjusted to a normal level.
- The definitions agreed in Heads of Terms shape the final figure, so negotiate them early.
- Take tax advice before deciding how to extract surplus cash.
Peter Hogan is the founder of Hogan Capital and has spent almost nine years working with owner-managed businesses, predominantly across mergers and acquisitions. More about Peter or connect on LinkedIn.
This article is general information and does not constitute financial, legal or tax advice. Figures are illustrative.