What does debt-free, cash-free mean in a business sale?

The convention, in one sentence each

Buyers price a business on what it earns. Earnings do not depend on how the seller financed the company or how much cash happens to be in the bank on closing day, so a buyer's offer is for the operating business alone. Debt-free, cash-free is the set of adjustments that makes that possible:

• Debt-free. Every loan, line of credit, equipment note, shareholder loan and cash advance is repaid at closing unless the buyer agrees to assume it, and liabilities agreed to be debt-like are deducted from the price.
• Cash-free. The seller sweeps the cash before closing or is paid for it dollar for dollar.
• Normal working capital. Receivables, inventory and payables are left at the level the business normally runs at, measured against a working capital peg, with the difference settled after closing.

The convention applies to asset purchases and stock purchases alike, though the mechanics differ. In an asset purchase the buyer simply does not assume the seller's debt, and the seller's lenders must release their liens so the assets transfer clean. In a stock purchase the company's debt comes with the shares, so it is paid off at closing out of the price, and it shows up as a separate use in the buyer's sources and uses.

From enterprise value to the seller's check

The headline price is enterprise value. The seller's proceeds are what is left after the adjustments. A simple bridge, with plain numbers:

Every line after the headline is a definition in the purchase agreement, and every definition is worth money to one side or the other. The two companion pages walk through the items most often argued: cash-free, debt-free for acquisition buyers covers what they do to the buyer's leverage, and cash-free, debt-free in the capital structure covers what they do to the equity the buyer brings.

What counts as debt

Funded debt is uncontroversial. The fights are over liabilities that behave like debt but sit in the accounts elsewhere. A rough map:

• Almost always debt: bank loans and lines, equipment loans, capital or finance leases where the agreement says so, loans from shareholders, merchant cash advances, accrued interest, and prepayment charges triggered by the payoff.
• Often treated as debt: income taxes owed for periods before closing, declared but unpaid distributions, deferred compensation, bonuses earned before closing but paid after, and payments owed to employees or others because the company is changing hands.
• Argued case by case: customer deposits and deferred revenue, where the buyer must deliver work the seller was already paid for; deferred rent; aged payables stretched beyond normal terms; unfunded obligations to retirement plans.
• Usually not debt: ordinary trade payables and accrued expenses. They are part of working capital and are already measured against the peg.

No liability should count twice. If an item is deducted as debt, it must be excluded from the working capital calculation, and the reverse.

The payoff at closing: where the new lender meets the old ones

Debt-free is not a promise the seller makes; it is something that happens on closing day, and the buyer's lender makes sure of it. The new loan will not fund until every existing creditor with a lien has confirmed what it is owed and agreed to release its security.

• Payoff letters. Each existing lender issues a payoff letter stating the balance on a given date, the daily interest after that, and wiring instructions, and committing to release its liens on receipt.
• Lien releases. Filed financing statements are terminated with a UCC-3, mortgages are released, and any guarantees the seller gave fall away.
• Funds flow. The closing funds flow sends payoffs directly to the prior lenders out of the price, before the seller receives anything.
• Cash advances. A merchant cash advance funder must produce a payoff and terminate its filing like any other creditor. Some are slow to do it, and a funder that has filed against all assets can hold up a closing. See paying off seller debt at closing.

A lien search early in the process shows which creditors will need to be paid off. It regularly finds filings the seller had forgotten: a paid-off equipment loan never terminated, or an advance taken out after the letter of intent. Finding them at the start keeps them from becoming closing-week problems.

Why the buyer's lender cares about the definitions

The buyer's lender sizes its loan on the business's earnings, on the assumption that nothing else has a claim on the cash ahead of it or alongside it. Any liability the purchase agreement leaves in the business is a claim the loan was not sized for.

Some of those items land directly in the lender's covenants. A finance lease left in the business is usually funded debt under the credit agreement, so it counts in the total leverage ratio from the first test date. Unpaid pre-closing taxes consume cash in the first months, exactly when the lender is watching coverage most closely. Customer deposits the seller collected and kept mean the buyer must do the work with no cash coming in, which strains working capital before the first payment is due.

This is why lenders read the purchase agreement's definition of indebtedness, and why a financing package should show the bridge from enterprise value to equity value rather than only the headline price. Where the definition is still being negotiated, the lender can underwrite the difference if it knows about it.

The cash the business still needs

Cash-free has a practical consequence that surprises first-time buyers. The seller takes the cash, but the business still has to make payroll on the Friday after closing. The working capital peg usually excludes cash, so the buyer inherits receivables that will turn into cash over the coming weeks and no bank balance to bridge the gap.

That opening cash has to be funded as a use in sources and uses: from the buyer's equity, from the term loan, or from a line of credit drawn at closing. See working capital at close and using a revolver in an acquisition. Some agreements instead leave a minimum level of cash in the business and add it to the price. Either way, the buyer pays for it; the question is only whether that is visible in the deal from the start.