What does cash-free, debt-free mean in an M&A deal? Completion accounts and an example

What does cash-free, debt-free actually mean, how does it work in practice, and should you use it in your next M&A deal? In short, it is a way of adjusting the purchase price so that the seller hands over the business free of debt and free of excess cash. If liabilities are left in the company at completion, the price comes down, typically pound for pound. If there is more cash than agreed, the price goes up. The adjustment is calculated from completion accounts and is usually applied to the part of the price the buyer has not yet paid.

Why use cash-free, debt-free in M&A deals?

To understand why the mechanism exists, start with how the price is paid. Usually only a percentage of the purchase price is actually paid on completion. The rest is typically deferred over a period of time, meaning it is payable after the business has already been bought.

Purchase price adjustments are then, in practice, made by increasing or decreasing those deferred payments that the buyer owes the seller. That is what makes a price adjustment workable. Nobody has to send money back; the outstanding balance simply changes. If the entire price had been paid on completion, any later adjustment in the buyer's favour would mean asking the seller to return money they have already received, which is a much harder conversation.

What are completion accounts?

The adjustment is driven by completion accounts. Completion accounts are financial accounts of the target company that show its financial position as at completion. In other words: on the day the buyer took ownership, what did the company's finances look like? How much cash was in the bank, what did the company owe, and how did that compare with what the parties expected when they agreed the price?

Depending on what the completion accounts show, the total purchase price is either increased or decreased, and that increase or decrease typically takes effect through the deferred payments. The accounts are usually produced a few weeks after completion, once the accountants for both sides have had the chance to look at the books as they stood on the day.

The three purchase price adjustment mechanisms

There are three main ways to adjust the purchase price in an M&A deal:

• On a locked box basis, where the price is fixed at an earlier date and the parties control what value leaves the business before completion.
• On a cash-free, debt-free basis, which is the subject of this article.
• On a net asset value basis, where the price moves with the difference between a target net asset value and the actual figure at completion.

I compare all three in locked box vs completion accounts. Here the focus is cash-free, debt-free.

How does cash-free, debt-free work?

Cash-free, debt-free simply means that the seller is supposed to hand over the business to the buyer free of any liabilities, that is debt, and free of any excess cash.

It is a mechanism for adjusting the price rather than a description of the business on the day. In practice the business will rarely be exactly cash-free and debt-free at completion, so the SPA says what happens when it is not:

• Liabilities left in the business adjust the purchase price downwards, typically pound for pound. If the seller hands over a company that still owes money, the buyer pays that much less.
• Excess cash works the other way. If there is more cash in the company's bank account than expected, the excess increases the purchase price, typically pound for pound. The seller is paid for the cash they are leaving behind.

The result is that the buyer pays for the trading business and not for the seller's bank balance or the seller's borrowing. Both sides know in advance that the number will move, and both know the rule by which it moves.

The reference to "excess" cash matters. The parties usually agree a target amount of cash that the business needs to keep trading after completion. Cash up to that target stays in the company and is part of what the buyer is paying for. It is only cash above the target that triggers an increase in the price.

Cash-free, debt-free worked example

Here is how this plays out on a real deal.

• The price. The purchase price is £1 million, of which £600,000 is payable on completion and £400,000 is deferred over a period of years.
• Completion. The deal completes and the buyer takes ownership of the company.
• Completion accounts. A few weeks later the accountants get together and produce the completion accounts, reflecting what the target company looked like as at completion.
• What the accounts show. As at completion the target owed £200,000 to a lender. However, the company also had £50,000 more cash than the target cash figure the parties expected it to hold.
• The adjustment. Start with £1 million. Reduce it by £200,000 for the liabilities. Increase it by £50,000 for the excess cash. That leaves £850,000, so the purchase price has effectively been decreased by £150,000.
• How it is paid. The buyer had been recognised as owing the seller £400,000 in deferred payments. The buyer now owes £150,000 less, so the deferred balance falls to £250,000.

Notice that the £600,000 paid on completion does not change. The whole adjustment is absorbed by the deferred consideration, which is exactly why having part of the price deferred is so useful when a cash-free, debt-free mechanism is used. Had the deferred element been smaller than the adjustment, the buyer would have had to recover the balance from the seller directly.

Notice also that the two adjustments net off against each other. The £200,000 loan and the £50,000 of extra cash are not treated separately; they are combined into a single £150,000 reduction. That is typical of how completion accounts work: one set of figures, one net adjustment.

Should you use a cash-free, debt-free mechanism?

In my experience it is one of the most straightforward mechanisms to explain to both parties, which is a real advantage when a deal is being negotiated between business owners rather than between finance teams. The buyer is protected against inheriting loans and unpaid bills. The seller is compensated for cash they leave in the business. The main practical requirement is that the parties agree, before completion, what the target cash figure is and what counts as a liability, so that the completion accounts can be prepared without argument.

Next steps

If you are negotiating a deal on a cash-free, debt-free basis, make sure the heads of terms say so, agree the target cash figure early, and keep part of the price deferred so the adjustment has somewhere to land. A corporate solicitor and your accountant should work on the completion accounts provisions in the share purchase agreement together.