Most of the focus in a transaction process is on maximising the value of the business on an Enterprise Value basis. This is usually arrived at by multiplying a profit number (often adjusted EBITDA) by a multiple. It gives a valuation which is comparable from business to business because it takes no account of individual funding structures or free cash balances.
However, the Equity Value (the amount actually due to the shareholders) has to be adjusted for those factors and the calculations around this adjustment can be a matter for great debate and frequently for disagreement, since there is room in it for interpretation and subjectivity.
Anyone who is considering selling their business should be aware of the elements of this calculation and should think about them in context of their own circumstances. Only with a realistic approach to negotiating the debt free/cash free adjustment will a deal happen. It is also an area where careful planning can improve the vendors’ overall outcome.
The principles underpinning the debt free/cash free adjustment are that an acquirer should inherit a business free of structural debt and with sufficient cash (only) to cope with the normal working capital cycle.
Debt to be paid for by the sellers will usually cover bank borrowing (including overdrafts, invoice discounting and other asset funding facilities), shareholder or director loans, intercompany balances, trade loan facilities, Hire Purchase and finance leases. It will also include a deduction relating to corporation tax due on profits to the date of completion
Depending on the circumstances, debt might also include deferred income (where cash has been received in advance and the business has an obligation to provide future products or services), lease dilapidations, deferred tax, accrued bonuses and any fees due for breaking debt facilities.
In order to calculate the amount of cash that the vendor needs to leave in the business to cover normalised working capital requirements, buyers are likely to look back at least a year to determine the scale of both the highest seasonal balance and intra-month peaks. They will not want to take a chance that they will have to invest further to support normal trading and are likely also to look ahead at short term forecast requirements to ensure sufficient cash headroom. Using this analysis they will set a target level of working capital (which normally includes trade creditors, trade debtors and stock) and there will be an adjustment to top this up with cash if the working capital at completion is lower than it needs to be.
Depending on how much cash is in the business, the agreed debt deduction and the agreed working capital adjustment might be taken either as a reduction in the free cash balance to be added to the value of the deal or, if there is insufficient cash in the business to cover it, there will be a deduction from the price.
So far, so straight forward, you might think. Except that there is often a great deal of discussion to be had to get to an agreed set of completion adjustments. For example:
Does Deferred income still represent a debt if there is no additional cost to be incurred by the company in delivering the product or service concerned ?
Is it reasonable to deduct deferred tax if there is no realistic prospect of the liability needing to be paid ?
What about lease or HP debts in asset heavy businesses (such as leasing companies) where the debt is closely associated with assets which are not separately valued in the deal ?
How to fairly quantify dilapidations if a business is part way through an arms length lease ?
What if trading patterns have changed/are changing and historic peaks are no indication of future ones ?
Should a vendor be allowed to include a potential R&D tax credit in the calculation of net corporation tax liabilities ?
I could go on. When all of these individual discussions and negotiations are set alongside each other the gap between a buyer and seller’s interpretation of a fair debt free/cash free adjustment can be sizeable without either of them being “wrong”.
So what can vendors do to ensure that the debt free/cash free adjustment doesn’t come as a sting in the tail at the end of a deal?
First, they can make sure they understand the elements in the calculation and the best case/worst case interpretation of their figures
Second, They can ensure they understand the principle of a buyer not having to inject cash to trade the business normally post deal and manage their business accordingly. To the extent that deferred revenue (for example) is not matched by future liabilities they should endeavour to track and evidence this over time
Third, they can manage their working capital efficiently in the years leading up to a transaction. A short term focus on debtor collection or a clumsy attempt to string out creditors will not work to minimise the requirement but a sustained effort at efficiency over a year or more should have a positive impact on the cash they ultimately get to keep. Spreading regular payments across the month to minimise an intra month peak might be worth considering.
Fourth, if there are mitigating factors in the tax calculation these should be explored and evidence collected to support the arguments, particularly in context of a changing regime or a potential move from annual to quarterly payments.
In short, this should be a focus for would-be vendors in the same way that maximising EBITDA and optimising a multiple tends to be. Starting from a position of knowledge and evidence and fielding compelling arguments with the relevant data is likely to result in the best possible outcome.
At the very least vendors should be aware of this potential sting in the tail and the debate that surrounds it …..
Most of the focus in a transaction process is on maximising the value of the business on an Enterprise Value basis. This is usually arrived at by multiplying a profit number (often adjusted EBITDA) by a multiple. It gives a valuation which is comparable from business to business because it takes no account of individual funding structures or free cash balances.
However, the Equity Value (the amount actually due to the shareholders) has to be adjusted for those factors and the calculations around this adjustment can be a matter for great debate and frequently for disagreement, since there is room in it for interpretation and subjectivity.
Anyone who is considering selling their business should be aware of the elements of this calculation and should think about them in context of their own circumstances. Only with a realistic approach to negotiating the debt free/cash free adjustment will a deal happen. It is also an area where careful planning can improve the vendors’ overall outcome.
The principles underpinning the debt free/cash free adjustment are that an acquirer should inherit a business free of structural debt and with sufficient cash (only) to cope with the normal working capital cycle.
Debt to be paid for by the sellers will usually cover bank borrowing (including overdrafts, invoice discounting and other asset funding facilities), shareholder or director loans, intercompany balances, trade loan facilities, Hire Purchase and finance leases. It will also include a deduction relating to corporation tax due on profits to the date of completion
Depending on the circumstances, debt might also include deferred income (where cash has been received in advance and the business has an obligation to provide future products or services), lease dilapidations, deferred tax, accrued bonuses and any fees due for breaking debt facilities.
In order to calculate the amount of cash that the vendor needs to leave in the business to cover normalised working capital requirements, buyers are likely to look back at least a year to determine the scale of both the highest seasonal balance and intra-month peaks. They will not want to take a chance that they will have to invest further to support normal trading and are likely also to look ahead at short term forecast requirements to ensure sufficient cash headroom. Using this analysis they will set a target level of working capital (which normally includes trade creditors, trade debtors and stock) and there will be an adjustment to top this up with cash if the working capital at completion is lower than it needs to be.
Depending on how much cash is in the business, the agreed debt deduction and the agreed working capital adjustment might be taken either as a reduction in the free cash balance to be added to the value of the deal or, if there is insufficient cash in the business to cover it, there will be a deduction from the price.
So far, so straight forward, you might think. Except that there is often a great deal of discussion to be had to get to an agreed set of completion adjustments. For example:
Does Deferred income still represent a debt if there is no additional cost to be incurred by the company in delivering the product or service concerned ?
Is it reasonable to deduct deferred tax if there is no realistic prospect of the liability needing to be paid ?
What about lease or HP debts in asset heavy businesses (such as leasing companies) where the debt is closely associated with assets which are not separately valued in the deal ?
How to fairly quantify dilapidations if a business is part way through an arms length lease ?
What if trading patterns have changed/are changing and historic peaks are no indication of future ones ?
Should a vendor be allowed to include a potential R&D tax credit in the calculation of net corporation tax liabilities ?
I could go on. When all of these individual discussions and negotiations are set alongside each other the gap between a buyer and seller’s interpretation of a fair debt free/cash free adjustment can be sizeable without either of them being “wrong”.
So what can vendors do to ensure that the debt free/cash free adjustment doesn’t come as a sting in the tail at the end of a deal?
First, they can make sure they understand the elements in the calculation and the best case/worst case interpretation of their figures
Second, They can ensure they understand the principle of a buyer not having to inject cash to trade the business normally post deal and manage their business accordingly. To the extent that deferred revenue (for example) is not matched by future liabilities they should endeavour to track and evidence this over time
Third, they can manage their working capital efficiently in the years leading up to a transaction. A short term focus on debtor collection or a clumsy attempt to string out creditors will not work to minimise the requirement but a sustained effort at efficiency over a year or more should have a positive impact on the cash they ultimately get to keep. Spreading regular payments across the month to minimise an intra month peak might be worth considering.
Fourth, if there are mitigating factors in the tax calculation these should be explored and evidence collected to support the arguments, particularly in context of a changing regime or a potential move from annual to quarterly payments.
In short, this should be a focus for would-be vendors in the same way that maximising EBITDA and optimising a multiple tends to be. Starting from a position of knowledge and evidence and fielding compelling arguments with the relevant data is likely to result in the best possible outcome.
At the very least vendors should be aware of this potential sting in the tail and the debate that surrounds it …..
Further to our recent article on the role of search funds as an alternative buyer group and the completion of the sale of the PCB fabrication and assembly business Garner Osborne, today we focus on this buyer class from a lending / debt funding perspective.
To recap, search funds are investment vehicles formed by a group of investors, lead by an experienced business operator (the “searcher”) to acquire a business. The process involves the searcher securing capital from investors to fund the initial phase of identifying and acquiring a business and the searcher being operationally involved in the running of the target business post transaction / buyout, often alongside the existing management teams, to drive growth.
Like a traditional LBO, searchers often use debt to enhance overall shareholder returns at the point of exit. However, search fund transactions present a distinct set of considerations for lenders. For example, searchers typically focus specifically on acquiring and actively managing a single business rather than investing in a portfolio of companies and whilst they may have run and operated similar businesses in the past, they are not part of the existing management team within the target.
Here, we’ll explore the key areas lenders scrutinise and what searchers can do to position themselves for success in securing debt for these types of transactions.
The importance of follow-on capital and aligned interests
One of the first things lenders will assess is whether there’s adequate follow-on capital to safeguard against underperformance post-acquisition. Covenant breaches, which can trigger a default, are always a concern. However, in search fund transactions, the situation can be further complicated by investors who might not be willing or able to put in additional equity to cure a covenant breach. This potential discord makes demonstrating a clear path to new equity critical.
Moreover, alignment of interests between the searcher and investors plays a pivotal role. Lenders want assurance that the searcher has “skin in the game” — typically in the form of a meaningful equity contribution. This shows commitment and mitigates the perception of risk.
Sector knowledge and business acumen
A core challenge for searchers is convincing lenders they have the expertise to successfully grow the acquired business given that they are not part of the incumbent management team. Without an investment track record, the burden of proof shifts to demonstrating deep relevant industry knowledge. Therefore, searchers who bring prior experience in the target sector, or at the very least closely related fields, stand a better chance of gaining lender confidence.
But technical know-how isn’t enough. Searchers must also exhibit the leadership and communication skills necessary to guide the company through its next phase of growth. This, in turn, reassures both lenders and investors that the searcher can serve as a capable bridge between all stakeholders.
A strong management team is the backbone of any search fund transaction
Given the long-term nature of search fund investments, lenders place significant weight on the strength and stability of the existing management team. A strong team, with the right incentives in place, is seen as a buffer against the learning curve that searchers may face. Lenders will scrutinise the experience and track record of each team member, looking for alignment between the searcher’s vision and the management’s commitment to executing that vision. This alignment can be created by putting in an appropriate equity incentive plan or where management have a minority stake in the target pre-transaction getting their commitment to roll that forward alongside the investors.
In cases where new leadership appointments are necessary, lenders will need confidence that these additions bring the right mix of skills and experience to complement the existing team.
Crafting a deal that works for all
Search fund transactions are bespoke rather than cookie cutter, and this means lenders will require a granular understanding of the proposed deal structure. For example, how much equity will the sellers reinvest in the business?
As noted above, a higher level of vendor roll-over equity can reassure lenders, as it aligns the seller’s interests with the future success of the business. Similarly, lenders will want clarity on how much capital will be required upfront versus how much can be deferred or linked to performance.
In cases where follow-on investments are part of the strategy, lenders will need to understand how those will be financed and what impact they might have on the business’ cash flow.
The critical role of cash flows
While stable profit and cash flow generation are a cornerstone of any debt-funded transaction, they become even more critical in search fund transactions where the buyer may be an unknown entity to the lender. Lenders will expect detailed due diligence, confirming that the target business has a solid history of profitability and cash generation. Moreover, the financial projections should be supported by recent financial performance and provide enough headroom for debt service obligations, especially given the added risk of an unproven searcher.
The road ahead for search funds in debt markets
Despite the unique challenges that come with funding search fund transactions, we expect this buyer group to continue its momentum in the lower mid-market space. The reliance on existing management teams provides a level of continuity that is attractive to lenders, and with the right preparation, searchers can position themselves to secure favourable debt terms.
Our recent experience has provided us with valuable insight into how different lenders view these structures and what steps searchers can take to tailor debt processes to meet these expectations. By focusing on the areas outlined above, searchers can not only mitigate lender concerns but also obtain flexible debt terms for long-term success.
In the end, securing debt for a search fund buyout is not just about ticking boxes — it’s about building confidence, demonstrating alignment, and crafting a deal that works for all parties involved.
Further to our recent article on the role of search funds as an alternative buyer group and the completion of the sale of the PCB fabrication and assembly business Garner Osborne, today we focus on this buyer class from a lending / debt funding perspective.
To recap, search funds are investment vehicles formed by a group of investors, lead by an experienced business operator (the “searcher”) to acquire a business. The process involves the searcher securing capital from investors to fund the initial phase of identifying and acquiring a business and the searcher being operationally involved in the running of the target business post transaction / buyout, often alongside the existing management teams, to drive growth.
Like a traditional LBO, searchers often use debt to enhance overall shareholder returns at the point of exit. However, search fund transactions present a distinct set of considerations for lenders. For example, searchers typically focus specifically on acquiring and actively managing a single business rather than investing in a portfolio of companies and whilst they may have run and operated similar businesses in the past, they are not part of the existing management team within the target.
Here, we’ll explore the key areas lenders scrutinise and what searchers can do to position themselves for success in securing debt for these types of transactions.
The importance of follow-on capital and aligned interests
One of the first things lenders will assess is whether there’s adequate follow-on capital to safeguard against underperformance post-acquisition. Covenant breaches, which can trigger a default, are always a concern. However, in search fund transactions, the situation can be further complicated by investors who might not be willing or able to put in additional equity to cure a covenant breach. This potential discord makes demonstrating a clear path to new equity critical.
Moreover, alignment of interests between the searcher and investors plays a pivotal role. Lenders want assurance that the searcher has “skin in the game” — typically in the form of a meaningful equity contribution. This shows commitment and mitigates the perception of risk.
Sector knowledge and business acumen
A core challenge for searchers is convincing lenders they have the expertise to successfully grow the acquired business given that they are not part of the incumbent management team. Without an investment track record, the burden of proof shifts to demonstrating deep relevant industry knowledge. Therefore, searchers who bring prior experience in the target sector, or at the very least closely related fields, stand a better chance of gaining lender confidence.
But technical know-how isn’t enough. Searchers must also exhibit the leadership and communication skills necessary to guide the company through its next phase of growth. This, in turn, reassures both lenders and investors that the searcher can serve as a capable bridge between all stakeholders.
A strong management team is the backbone of any search fund transaction
Given the long-term nature of search fund investments, lenders place significant weight on the strength and stability of the existing management team. A strong team, with the right incentives in place, is seen as a buffer against the learning curve that searchers may face. Lenders will scrutinise the experience and track record of each team member, looking for alignment between the searcher’s vision and the management’s commitment to executing that vision. This alignment can be created by putting in an appropriate equity incentive plan or where management have a minority stake in the target pre-transaction getting their commitment to roll that forward alongside the investors.
In cases where new leadership appointments are necessary, lenders will need confidence that these additions bring the right mix of skills and experience to complement the existing team.
Crafting a deal that works for all
Search fund transactions are bespoke rather than cookie cutter, and this means lenders will require a granular understanding of the proposed deal structure. For example, how much equity will the sellers reinvest in the business?
As noted above, a higher level of vendor roll-over equity can reassure lenders, as it aligns the seller’s interests with the future success of the business. Similarly, lenders will want clarity on how much capital will be required upfront versus how much can be deferred or linked to performance.
In cases where follow-on investments are part of the strategy, lenders will need to understand how those will be financed and what impact they might have on the business’ cash flow.
The critical role of cash flows
While stable profit and cash flow generation are a cornerstone of any debt-funded transaction, they become even more critical in search fund transactions where the buyer may be an unknown entity to the lender. Lenders will expect detailed due diligence, confirming that the target business has a solid history of profitability and cash generation. Moreover, the financial projections should be supported by recent financial performance and provide enough headroom for debt service obligations, especially given the added risk of an unproven searcher.
The road ahead for search funds in debt markets
Despite the unique challenges that come with funding search fund transactions, we expect this buyer group to continue its momentum in the lower mid-market space. The reliance on existing management teams provides a level of continuity that is attractive to lenders, and with the right preparation, searchers can position themselves to secure favourable debt terms.
Our recent experience has provided us with valuable insight into how different lenders view these structures and what steps searchers can take to tailor debt processes to meet these expectations. By focusing on the areas outlined above, searchers can not only mitigate lender concerns but also obtain flexible debt terms for long-term success.
In the end, securing debt for a search fund buyout is not just about ticking boxes — it’s about building confidence, demonstrating alignment, and crafting a deal that works for all parties involved.
