Cash-free, debt-free means the price is for the operating business alone. The seller keeps the company's cash, pays off its debt from the proceeds and leaves a normal level of working capital behind. The argument is over what counts as debt. Capital leases, accrued bonuses, customer deposits, deferred revenue and unpaid taxes can each be deducted from the price or left in the business. Every dollar classified as debt comes straight out of the seller's proceeds, and every dollar left out becomes an obligation the buyer funds after closing, with equity or with borrowing.
- What the price buys
- The operating business, valued on its earnings
- Cash
- Kept by the seller, or added to the price if left in
- Debt
- Paid off from the seller's proceeds at closing
- Working capital
- A normal level delivered, measured against a peg
- Where the money is argued
- The purchase agreement's definition of indebtedness
- Why the lender reads it
- Anything left in the company counts against the buyer's leverage and cash from day one
Enterprise value in, equity value out
A buyer prices a private company on its earnings, usually a multiple of adjusted EBITDA. That multiple produces enterprise value: what the operating business is worth regardless of how it happens to be financed today. It says nothing about the cash in the account on closing day or the loans the owner took out along the way.
Cash-free, debt-free converts enterprise value into what the seller actually receives, the equity value. Cash in the business is the seller's, so the seller takes it out before closing or is paid for it. Debt is the seller's too, so it is repaid from the proceeds and the company arrives unencumbered. Working capital is the one balance that stays, because the business cannot operate without it; the working capital peg sets how much.
The convention is the norm in lower-middle-market sales, and it is fair to both sides. The seller is not paid twice for cash that is already theirs, and the buyer does not pay a full multiple for a company and then inherit its loans. The disputes are about the edges: balances that are not bank debt but behave like it.
Cash-free, debt-free is settled in principle in the letter of intent. The money is in the definition of debt, which is usually written weeks later.
From headline price to the seller's check
Take a company sold for an enterprise value of 8,000. Its balance sheet at closing shows a bank term loan of 1,200, 300 drawn on a line of credit, equipment capital leases of 250, last year's bonuses accrued but unpaid of 120, income tax of 180 owed for periods before closing, 350 of customer deposits for work not yet done, 200 of deferred revenue on prepaid service contracts, and 500 of cash. Working capital is delivered exactly at the peg, with deposits and deferred revenue measured outside it.
| Only bank debt counts | Every debt-like item counts | |
|---|---|---|
| Enterprise value | 8,000 | 8,000 |
| Less term loan and line of credit repaid | (1,500) | (1,500) |
| Less capital leases | left in | (250) |
| Less accrued bonuses | left in | (120) |
| Less pre-closing income tax | left in | (180) |
| Less customer deposits and deferred revenue | left in | (550) |
| Proceeds to the seller at closing | 6,500 | 5,400 |
| Cash the seller keeps | 500 | 500 |
| Obligations the buyer inherits without a price reduction | 1,100 | 0 |
The seller's check moves by 1,100 on a single definition, with no change to the headline price, the multiple or the business. That is why experienced sellers negotiate the definition of debt as hard as the price, and why buyers who skip it end up paying more than they agreed.
The items that get argued over
Bank loans, drawn lines and loans from shareholders are debt on anyone's definition. The arguments start with balances that are operating in form but financial in substance.
| Item | Seller's argument | Buyer's argument | How a lender treats it if left in |
|---|---|---|---|
| Capital or finance leases | An operating cost already inside EBITDA | A fixed payment for an asset, the same as an equipment loan | Usually funded debt in the leverage covenant |
| Accrued bonuses and commissions for past periods | Normal accruals, part of working capital | Earned under the seller's ownership, paid with the buyer's cash | A near-term cash call against the first months' liquidity |
| Customer deposits | Working capital; they reverse as work is delivered | The seller took the cash, the buyer does the work | Cost of delivering work with no cash coming in |
| Deferred revenue on service contracts | Part of the business's normal operation | Revenue already collected by the seller for future service | Same as deposits: cost without collection |
| Income taxes for pre-closing periods | Settled through the tax provisions | A liability of the seller's period | In a stock purchase, a claim ahead of the lender's cash flow |
| Payables stretched beyond normal terms | Ordinary trade credit | A loan from suppliers the buyer must repay to restore terms | Drawn on the revolver to catch up |
| Deferred compensation or sale bonuses to staff | Retention costs that benefit the buyer | Triggered by the seller's sale | A payment ahead of debt service |
| Declared but unpaid distributions | Owed to the owners already | Owed to the seller, so it is the seller's to fund | Cannot be paid from SBA loan proceeds |
The last row has a hard rule behind it on SBA deals: SBA loan proceeds cannot fund a distribution to owners, or refinance debt that did. A distribution the seller declared and never paid has to be settled from the seller's side, not folded into the loan.
There is no universal answer for most rows. Customer deposits in a custom manufacturer, deferred revenue in a maintenance business and accrued bonuses in a staffing firm are each large enough to decide a deal, and each is argued on the facts. What matters is that every item is placed somewhere deliberately: deducted as debt, measured inside the peg, or accepted by the buyer with eyes open.
What the definition does to the buyer's equity
The lender sizes its loan on the business's earnings and cash flow, not on the definition of debt. To keep the example simple, suppose the senior lender will lend 4,000 against this company either way; the next section explains why items left in can shrink that loan. The buyer's side of the example then looks like this:
| Only bank debt counts | Every debt-like item counts | |
|---|---|---|
| Paid at closing, to the seller and to retire the seller's debt | 8,000 | 7,450 |
| Funded by the senior loan | 4,000 | 4,000 |
| Equity the buyer brings at closing | 4,000 | 3,450 |
| Obligations to fund after closing | 1,100 | 550, with the price already cut for them |
| Effective cost of the business | 9,100 | 8,000 |
On the narrow definition, the buyer's equity at closing is higher, and there is a further 1,100 of obligations to meet in the first months. That money comes from one of three places: more equity, a draw on the revolver, or cash the business was expected to use for debt service. The second and third are what a lender worries about. A revolver drawn to pay last year's bonuses raises leverage above the model, and cash spent delivering prepaid work is cash not available for the first loan payments.
It also reaches the buyer's own cash. For a complete change of ownership financed with an SBA 7(a) loan, SBA requires an equity injection of at least 10% of total project costs. Obligations the price did not account for sit outside that calculation, but they still need cash, and a buyer who has put everything into the injection has nothing left to meet them. See how much equity you need to buy a business.
Two definitions of debt: the seller's and the lender's
The purchase agreement's definition of indebtedness decides the seller's check. The credit agreement's definition of funded debt decides the buyer's covenants. They are drafted by different lawyers for different purposes, and they do not have to match.
A capital lease that the seller successfully argued was an operating cost stays in the company and does not come off the price. The lender's credit agreement will still count it in funded debt, so the buyer starts with higher leverage than the financing model showed and less covenant headroom from the first test date. Where the lender sizes to a leverage limit, the lease also takes up room the new loan would otherwise have used. The reverse also happens: an item the buyer deducts as debt may not be debt to the lender at all, which is fine for the buyer but does not raise the loan.
The practical rule is to write the purchase agreement's definition with the lender's in view. The buyer's lender will ask for the target's full debt schedule, a lien search and payoff letters for everything being retired at closing. Anything on the debt schedule that is not being paid off is something the lender will count.
If you are the seller
- Know your own debt-like items before you set an asking price. A seller who quotes a price without knowing its deposits, deferred revenue and accrued bonuses is quoting an equity value it may not receive.
- Clean up what you can before the sale. Paying accrued bonuses, settling tax balances and bringing payables to terms in the normal course removes arguments rather than winning them.
- Argue the items on their facts. Deposits that are routinely converted into revenue within weeks have a better case for working capital treatment than a multi-year prepaid contract.
- Remember that paying off debt at closing is your check, not the buyer's. Loans and advances with a lien on the business are normally paid from your proceeds, and leases too unless the buyer agrees to take them over; see what happens to the seller's loans at closing.
If you are the buyer
- List every debt-like item, with amounts, before the letter of intent. A latest balance sheet and debt schedule are enough to see the size of the argument.
- Decide where each item goes. Debt, working capital, or accepted; nothing should fall between the definitions by accident.
- Match the lender's definition. Ask how your lender will count leases, deferred revenue and seller-period taxes before agreeing to leave them in.
- Put the obligations in the sources and uses. If the business will have to fund items after closing, the sources and uses should show where that money comes from.
A debt schedule is on Transparent's document checklist for every kind of loan, and the lender package shows each lender which obligations are retired at closing and which the business carries forward. The acquisition-specific mechanics, including estimates and true-ups after closing, are on cash-free, debt-free in an acquisition, and the short definition is in the glossary.
Common questions
- Does cash-free mean the buyer receives a company with no cash at all?
- Not in practice. The seller removes excess cash, but the business needs operating cash to run. Some agreements require a minimum balance to be left and count it in working capital or add it to the price; others expect the buyer to fund it at closing.
- Are capital leases debt in a cash-free, debt-free deal?
- Buyers usually treat them as debt, and lenders usually count them in funded debt. Sellers sometimes argue they are an operating cost. If they stay in the company without a price reduction, the buyer carries the payments and the leverage.
- Why do customer deposits matter so much?
- Because the seller has already collected the cash and the buyer has to do the work. If deposits are neither deducted from the price nor counted in working capital, the buyer pays for that work twice.
- Is cash-free, debt-free the same in an asset purchase?
- The idea is the same, but it is simpler. In an asset purchase the seller's entity usually keeps its cash and its loans, and the buyer takes only the liabilities it agrees to assume. Deposits and deferred revenue still need to be dealt with if the buyer takes over the customer contracts.
- Does the definition of debt change how much I can borrow?
- It can. The lender sizes the loan on earnings and coverage, but anything it counts as funded debt that stays in the company, such as capital leases, uses up part of the leverage it will allow, so the new loan can be smaller. The definition also changes how much equity you bring at closing and how much of the business's cash and revolver is already spoken for on day one.