Cash-Free/Debt-Free

What does cash-free/debt-free mean?

Cash-free/debt-free (in German: frei von Barmitteln und Finanzschulden, that is, free of cash and financial debt) is a purchase price rule in company acquisitions: the buyer values the ongoing business as if the company had neither bank balances nor financial debt. A normal level of working capital is also assumed, that is, inventories and customer receivables less outstanding supplier invoices. The price determined in this way is the enterprise value (Enterprise Value). The purchase price for the shares, the equity value (Equity Value), is obtained by deducting the actual financial debt at the reference date and adding the cash. If working capital deviates from the normal level, this is also settled.

When taking over a restaurant, the buyer and the previous owner can first agree on a price for the business. The money in the till and an outstanding loan for the kitchen are accounted for separately: the cash in the till is added to the price, and the loan is deducted.

In European company acquisitions, the mechanism is the usual starting point for offers. It already appears in the first, non-binding offer (indicative offer) and in the letter of intent, usually as a note that the price is understood “on a cash-free/debt-free basis”. In the purchase agreement it is implemented as a purchase price formula with the associated definitions; this provision is also called the cash-free/debt-free clause. It primarily concerns the Share Deal, the purchase of the company shares, in which the company changes hands with all its balances and debts. This allows buyers to value companies with very different financing on a uniform basis, and sellers to compare the offers with one another.

The purchase price formula under cash-free/debt-free

The assumption of a company free of debt and cash is a calculation device. The company does not have to empty its accounts or repay its loans; the purchase price is determined as if that had happened.

Formula: Purchase price for the shares = enterprise value − financial liabilities − debt-like items + freely available cash + (working capital at the reference date − target value)

• The starting point is the agreed enterprise value.
• Deducted are the financial liabilities, such as bank loans and shareholder loans, and the agreed debt-like items at the reference date. Debt-like items are obligations that act like debt economically, such as pension provisions or sale-related bonuses.
• Added is the freely available cash at the reference date.
• If working capital is below the agreed target value, the value in brackets is negative and reduces the purchase price; a surplus increases it.

The calculation itself is the bridge from the enterprise value to the purchase price for the shares (Equity Bridge); cash-free/debt-free is the underlying contractual decision that triggers it. Economically, the seller receives the liquidity left in the company and bears the debts not repaid. Whether loans are repaid at closing is a question of payment mechanics. The buyer often pays part of the purchase price directly to the financing banks, which release their collateral in return. In a debt-financed purchase by a financial investor (leveraged buyout, LBO), the existing loans are usually repaid, because the buyer's acquisition financing takes their place. This does not change the purchase price for the shares.

Surplus liquidity can also be distributed to the shareholders before closing. This requires that distributable profits exist and that the assets needed to maintain the share capital do not flow to the shareholders (Section 30(1) of the German Limited Liability Companies Act, GmbHG). The economic result is similar, but the tax result is not necessarily so, because a profit distribution and a gain on disposal can be treated differently for the seller. The choice therefore belongs in the tax preparation of the sale.

Provisional and final purchase price

Between the signing of the contract (signing) and closing, the day on which shares and purchase price pass, weeks or months often go by. A common reason is that an authority must first clear the acquisition, such as the competition authority in merger control or the competent federal ministry in investment screening. The parties therefore have to decide at which point in time debt, cash and working capital are measured. Two approaches are available.

Completion accounts (accounts at the closing date)

In the purchase price adjustment based on completion accounts (Completion Accounts), the reference date is the closing date. Shortly before, the seller presents an estimate from which the provisional purchase price results, which is paid at closing. Afterwards, the buyer, who now has access to the accounting, often prepares the completion accounts. The seller reviews them within a contractual period, relying on agreed inspection and information rights, and can raise objections. The final purchase price results in an additional payment or a refund, for which part of the purchase price is often deposited in an escrow account.

Fixed price at an earlier reference date (locked box)

With the locked box mechanism, the purchase price formula is applied to a balance sheet that already exists. The purchase price is fixed at signing, no adjustment after closing takes place, and the results of the business economically belong to the buyer from the balance sheet date. In return, no value may flow to the seller until closing. The cash-free/debt-free principle is retained; only the time of measurement shifts forward. The approach is regarded as seller-friendly and is common in auction processes with several interested buyers, but it requires a reliable, preferably audited balance sheet.

Dispute resolution by an independent expert

If the parties cannot agree on individual items of the completion accounts, an independent expert (Schiedsgutachter under German law) decides, according to widespread contractual practice, usually an independent audit firm. Legally, the rules on determination of performance by a third party apply to the expert by analogy (Sections 317 to 319 of the German Civil Code, Bürgerliches Gesetzbuch, BGB). The expert opinion binds the parties and can be reviewed by the courts only to a limited extent, namely as to whether it is manifestly incorrect (Section 319(1) BGB by analogy).

Unlike an arbitral tribunal, the independent expert does not decide a legal dispute but determines figures. Purchase agreements therefore often limit the expert's remit to the disputed items and the application of the agreed accounting principles. They also regulate the expert's selection if the parties cannot agree, the deadlines and the allocation of costs, often in proportion to success.

Cash-free/debt-free in an asset deal

In an Asset Deal, the buyer acquires individual assets and assumes only expressly agreed liabilities. Financial debt and bank balances generally stay with the seller, who repays the loans from the proceeds. The formula is therefore shortened, and the purchase price corresponds largely to the value of the transferred business.

Adjustments are nevertheless made where inventories, receivables or customer prepayments transfer and where the buyer assumes debt-like obligations. One example is occupational pension entitlements (Versorgungsanwartschaften) of employees whose employment relationships pass to the buyer under Section 613a BGB. Statutory liability risks also arise if the buyer continues the business name (Section 25 of the German Commercial Code, Handelsgesetzbuch, HGB) and for business taxes (Section 75 of the German Fiscal Code, Abgabenordnung, AO). The purchase agreement balances them through indemnities, that is, undertakings by the seller to reimburse such burdens.

Worked example: calculating the purchase price on a cash-free/debt-free basis

A buyer offers an enterprise value of EUR 24 million on a cash-free/debt-free basis for a software company. EUR 2.0 million is agreed as the target value for normal working capital; the contract provides for completion accounts and a retention of EUR 0.5 million in an escrow account.

• Seller's estimate at closing: financial debt EUR 3.5 million, cash EUR 1.8 million, working capital EUR 1.7 million
• Provisional purchase price: 24.0 minus 3.5 plus 1.8 minus (2.0 minus 1.7) = EUR 22.0 million
• Payment at closing: 22.0 minus 0.5 retention = EUR 21.5 million
• Buyer's completion accounts: financial debt EUR 3.6 million because of previously unrecorded interest, cash EUR 1.6 million, working capital EUR 1.9 million
• Final purchase price: 24.0 minus 3.6 plus 1.6 minus (2.0 minus 1.9) = EUR 21.9 million
• Settlement: 22.0 minus 21.9 = EUR 0.1 million in favour of the buyer, taken from the retention
• Release to the seller: 0.5 minus 0.1 = EUR 0.4 million; total proceeds 21.5 plus 0.4 = EUR 21.9 million

The offer of EUR 24 million thus becomes EUR 21.9 million for the seller; the difference is fully explained by debt, cash and working capital. If the seller disputes the interest, only this item goes to the independent expert. Many contracts release the undisputed part of the retention beforehand.

Distinctions: cash-free/debt-free, equity bridge and locked box

• Equity bridge: the reconciliation calculation with all individual items. Cash-free/debt-free is the pricing mechanism that prescribes this calculation.
• Locked box and completion accounts: two approaches that determine when the items are measured. Both presuppose the cash-free/debt-free principle.
• Working Capital Adjustment: the component of the formula that settles deviations from normal working capital.
• Earn-Out: a variable part of the purchase price that depends on future performance. The purchase price formula, by contrast, is tied to balance sheet values at the reference date.

Common mistakes

• Offers compared by enterprise value. Bidders who define debt and working capital differently deliver different proceeds for the same headline figure.
• Target value without derivation. A target value for working capital that is not derived from monthly figures can hardly be defended in negotiation.
• Accounting principles without a hierarchy. A customary order is: expressly agreed individual rules, consistency with the last annual financial statements and the general principles of the HGB. Without it, the parties argue about the method instead of the number.
• Objection deadline missed. Many contracts provide that the completion accounts become binding if the seller does not object in time and with reasons.
• Estimate too optimistic. An overstated provisional purchase price leads to repayments and strains the relationship with the buyer.
• No security for the settlement. Without a retention, a refund is hard to enforce against several sellers.

Frequently asked questions

Does the seller receive the company's liquid funds?

Yes, economically through the addition to the purchase price. The funds remain in the company, and the seller is paid for them.

How is the purchase price calculated under cash-free/debt-free?

From the agreed enterprise value, financial liabilities and debt-like items are deducted, freely available cash is added and the deviation of working capital from the target value is settled. In the worked example, this gives 24.0 minus 3.6 plus 1.6 minus 0.1 = EUR 21.9 million.

Does the company have to repay its debts before the sale?

No. The mechanism deducts the debts from the purchase price. Whether they are repaid at closing depends, first, on whether the buyer wants to continue the existing financing. Second, it depends on whether the loan agreements give the bank a right of termination when a new majority owner joins (change of control).

How long does it take until the final purchase price is known?

In practice often three to six months after closing. The period results from the deadlines for preparation, review and objections; an expert determination extends it.

Does cash-free/debt-free also apply in funding rounds?

No. In a funding round, an equity value is negotiated, and the existing liquidity and debt are already included in it.

The Roemer Capital view

Before documents are sent to bidders, we work with the client to derive the target value for normal working capital from the monthly figures of the last 12 to 24 months. At the same time, we define which items count as financial debt and cash. Bidders are asked to submit their offers on this basis so that the figures are comparable.

Whether locked box or completion accounts fits better, we assess on the basis of the quality of the available financial statements and the competitive situation in the process. The client's law firm drafts the purchase price clause and the expert determination procedure; we help calculate the estimate at closing and accompany the review of the completion accounts.