Financial Due Diligence - Net Debt in a Business Transaction
When buying or selling a business, the deal is often completed on a debt and cash free basis. As a result, debt and cash need to be identified in order to be adjusted out of the purchase price.
This article is written to cover the basics of net debt and financial due diligence considerations.
Purchase Price Impact
The completion mechanism within a Sale and Purchase Agreement (SPA) provides for a dollar for dollar adjustment to the base purchase price for net debt. As such, if a debt-like item is identified and agreed upon by both the buyer and seller, the purchase price would decrease by that amount.
When net debt is not correctly identified, it increases the overall funding requirements of the transaction (i.e., requires a higher investment by the buyer for the same earnings). As such, this would reduce the return on the investment for the buyer
Determining Net Debt
Net debt is defined as debt less cash. However, debt is not just "reported" debt and cash is not just "reported" cash. Debt includes "debt-like" items and cash excludes "trapped" cash.
Debt-like items include reported debt, such as bank loans and accrued interest, in addition to items with debt-like features. Examples of these may include:
Litigation costs and/or settlement
Management year-end bonuses
Future commitments and obligations
Debt break costs
Change in control payments
Cash includes reported cash and short-term securities. Examples of items that are classified as cash but are not freely available may include:
Cash trapped in overseas jurisdictions
Cash held in escrow
Bank deposits held as security
Financial due diligence helps a buyer identify potential debt-like items and trapped cash of a Target, however, many times these items are subject to negotiation between the buyer and seller.
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Disclaimer: The information contained in this article is for general guidance only. The information presented should not be acted upon without the advice and guidance of a professional tax, legal, or financial adviser who is familiar with all the relevant facts.