By Natasha Dinneen

One thing that frustrates many of our clients is that it’s hard to find a comprehensive definition of net debt, or a simple explanation of why the price offered by a buyer isn’t usually the amount of cash received on completion – until now.

In every M&A transaction, there is a difference between the total amount offered by the buyer for a company (Enterprise Value) and the total amount actually paid by the buyer (Equity Value) – the difference in the simplest example is Net Debt.

Enterprise Value – Net Debt = Equity Value

In practice, this formula is more complicated than stated above, but I’ll start with the basics.

Enterprise Value, which reflects the buyer’s valuation of a company, is adjusted by the amount of debt in the business net of any cash existing in the business available to repay that debt. For example, a buyer might value a company at $500m, but won’t pay $500m if that company has $50m of debt and only $25m of cash to repay this debt (leaving a future exposed liability of $25m).

Therefore, in practice, the amount paid by the buyer will be lower than $500m because reasonably a buyer assumes that the company they are acquiring will be “clean” (i.e. all debt repaid before the existing shareholders of a company are paid for their equity).

As with working capital, the perspectives between a buyer and seller can come into conflict when negotiating net debt. Buyers will want to show the company has a high net debt position so as to pay the lowest consideration; sellers will want to demonstrate the company has a low net debt position in order to attract the highest consideration.

What is included in net debt?

External debt (e.g. bank overdrafts, bank loans) clearly cannot be disputed by buyers and sellers as debt in the company. However, buyers may try to include additional balance sheet items as part of net debt, and typically ask whether the item is a liability related to pre-transaction activities.

Common examples include:

Net debt items	Buyer position	Seller response
Transaction fees	Costs attributable to the sellers	Incremental costs incurred for additional unexpected fees, due to requests from the buyer during the transaction, should be shared or be for the account of the buyer
Transaction bonuses or management incentive payments	Incentives offered by the company pre-transaction should be paid by the company	Typically conceded
Dilapidation provisions	Costs incurred as a result of not maintaining company property before ownership should be borne by sellers	Unlikely to incur this as a future expense, especially if the landlord has already withheld a rental deposit
Pension deficit	Historical funding shortfall for account of the sellers	Level of obligation to be determined by pension specialist
Legal claims	Pre-ownership legal matters should be settled by the sellers	May receive settlement, rather than have to pay out for the claim – to be considered on case-by-case basis
Customer claims, warranties and discounts	Costs related to pre-transaction sales	Part of ordinary course of business, should be included in working capital
Deferred income	Sellers should leave this cash in the business as ongoing cost of servicing customer contracts	Part of ordinary course of business, should be included in working capital as the balance is not expected to unwind and will constantly replenish
Corporation tax payable	Pre-transaction obligations due after completion should be paid by the seller	Recurring expense, should be included in working capital. Timing of obligation to be considered
Capital expenditure	Outstanding payments, arising from the purchase of new equipment pre-transaction, should be paid by the sellers	Typically, these are not material for software companies, or are part of ordinary course of business e.g. laptops, required fixtures and fittings, etc.

Bridge from headline price to take-home cash

As alluded to above, the bridge between Enterprise Value and Equity Value is comprised of several calculations and the difference is not just net debt for most companies. This bridge is fundamental to every M&A transaction as it connects the total value of the business to the amount paid by the buyer. Each item below is calculated separately and negotiated individually. The following example sets out the bridge for a Locked Box completion mechanism, but the same principles apply for a completion accounts mechanism:

Enterprise Value		X	Total amount offered for the company by the buyer
Net debt	(A)   Cash and cash-like items	Add (A)	See cash-free, debt-free jargon buster for further guidance
	(B)   Debt-like items	Subtract (B)	See cash-free, debt-free jargon buster
Tax	(C)   Tax items	Add or Subtract (C)	Dependent on whether there are outstanding tax liabilities or if the company is due repayment of tax (e.g. R&D tax credits)
Working capital	(D)   Net working capital adjustment = net working capital at the Locked Box date LESS target net working capital	Add or Subtract (D)	See net working capital jargon buster for further guidance
Cash profits	(E)   Post Locked Box profits adjustment	Add (E)	Cash profits expected to be earned by the company between the Locked Box date and completion date (if there is difference in timing between the two)
Equity Value		X	Sum total of the above, cash received on completion

Although this bridge seems daunting, it is our job at FirstCapital to help our clients navigate this calculation. Our approach enables us to narrow the gap between Enterprise Value and Equity Value to achieve the best possible result from negotiations. The sums involved can be substantial, so it pays to negotiate rigorously around the different items.