A Guide Price for a business may well be described along similar lines to the following:
“£XXX for 100% of the shares of XYZ Ltd on a debt free, cash free basis”
In the sale of a limited company, shares rather than assets are usually sold because of the significant benefits which are available to the seller under Entrepreneur’s Relief tax legislation. However, the sale of shares introduces the principle of ‘debt free cash free’ and this article discusses the what, why, and how of this principle.
What is ‘debt free cash free’?
• It means that when a purchaser buys the shares of a business, at the point of completion they inherit a balance sheet that is free of all bank and other debt (eg amounts due/owed to directors) and is also free of surplus cash.
Why is ‘debt free cash free’ used?
• To make offers comparable. Cash and debt levels in a business fluctuate daily. The debt free cash free value provides a consistent way of measuring the value of the business, irrespective of these fluctuations.
• It is logical. The level of debt in a business, is to a great extent, a decision for the owner. By some financial theories, some debt in the overall financing structure is earnings-enhancing. In practice, however, most debt arises simply because shareholders decide to withdraw cash from the business which would otherwise be used to fund the business and hence borrowings replace this cash.
• It is convention within the corporate finance community.
How does debt free cash free work in practice?
• Debt - it is the vendor’s responsibility to clear all bank and other debt (eg due to/from directors) prior to completion. The usual exception to this is HP/Lease finance which generally transfers with the business. In industries where it is standard practice to have invoice based finance (eg temporary recruitment agencies), this may also be excluded and transferred with the business.
• Cash - it is the vendor’s right to either withdraw any surplus cash at Completion, or better still (for tax reasons), to add this to the consideration due. The calculation of what constitutes surplus cash is a matter for the accountants to work out, but the principle is that a business which is in ‘good health’ should be left by the vendor with sufficient cash to not need to borrow in the short term to support normal trading. The value is derived by projecting the peak cash requirement of the business in the next 3 months or so. Hence, if a large VAT payment is due a couple of weeks after completion the vendor would be expected to leave sufficient cash in the business to clear this.
The above is a very brief run through what can be quite a complicated topic and if more information is required, please contact Anderson Shaw.