There's no doubt understanding the value of your business is important, but even more important is determining the amount of total cash that will land in your bank account at the end of a deal transaction to sell your business. I have seen a number of transactions where the business owners are surprised at the end of the deal when they get much less cash than expected. These owners had a number in their head based on the total transaction value, but when fees and other payouts are made from the total proceeds, the remaining amount can cause disappointment for the vendor.
Business owners must insist that their M&A advisors provide a detailed analysis of the net cash proceeds that they will receive from the sale of their business. Take my word that this amount is much more important than the overall business valuation.
Net Cash Proceeds Case Study
Let’s use a simple case study of a business sold for a total transaction value of $25 million to provide an illustration on how net cash proceeds are determined. Here is a summary of five areas that impact the amount of cash a business owner will extract from the transaction on the day of closing:
Debt Free, Cash Free
The total transaction value (in this case $25 million) is commonly considered to be on a debt free, cash free basis. This means that a business that is sold is transferred to a buyer with no third party debt (other than accounts payable included in working capital) and also with no cash on its balance sheet at closing. Other redundant assets would be removed from the transaction as well.
You will need to work closely with your advisor to determine the debt obligations that will be settled prior to the closing of the transaction and also how much cash can be extracted before closing. There may also be penalties on early retirement of debt that should be considered. These amounts will obviously affect the net proceeds that you receive from the deal. So, in our case study, let’s add the following assumptions:
- $500,000 of cash on the closing balance sheet
- $2 million of long-term debt will be repaid (this includes prepayment penalties)
Seller financing is a common deal mechanism that is required in mid-market transactions. These amounts will not be paid at closing and will be paid at some point in the future. There may also be other deferred payments, such as holdbacks held in escrow. These amounts are held to cover a potential obligation and will only be paid when certain conditions are achieved. Let’s assume the following:
- Seller financing on the transaction equal to $2.5 million
- Holdbacks of $1 million to cover potential warranty issues
The next outlay that will impact your net cash proceeds are taxes. Your advisors should clearly demonstrate how the proceeds from the transaction will be taxed and distributed to you personally. The type of transaction (asset versus shares sale) and method of distribution will have different tax consequences for the deal. Your regional jurisdiction will also impact how those proceeds are taxed.
There may also be an opportunity to defer taxes through a holding company, but you should ultimately know what the net tax proceeds will be when all of the cash is distributed to you personally. This is a complex area of expertise and there are many options available to minimize tax, so it is recommended that you find a qualified tax expert to explore all potential tax options available. Estimate what the expected taxes will be in the transaction and continually revise these estimates as the deal progresses. The taxes paid on the sale of a business will vary depending on the situation, but will undoubtedly be a significant portion of the proceeds.
- In our case, taxes payable are expected to be $3.5 million
Purchase Price Adjustments
Purchase price adjustments come in many forms with the most common being an adjustment to working capital. Normally, an appropriate level of working capital (referred to as target working capital) will be negotiated in the purchase and sale agreement. Typically, the purchase price will be increased or decreased dollar-for-dollar for the amount that the actual working capital at closing is above or below the target working capital. This working capital adjustment will usually get settled 60 to 90 days post-closing once accountant-prepared financial statements are finalized and actual working capital is determined.
The difficulty with determining the working capital adjustment is that it is a moving target. Your M&A advisors will need to forecast where they expect working capital to be at closing. In our case, let’s assume the following:
- Target working capital has been negotiated at $2.5 million and actual working capital anticipated at closing will be $2.2 million (i.e. net working capital adjustment is a $300,000 repayment)
At the end of the transaction, legal, accounting and M&A advisor fees will be owed and will reduce the net proceeds that a business owner will receive in his or her pocket. M&A advisory fees to brokers or investment banks can be estimated shortly after a deal transaction and structure is determined. I am often puzzled why more business owners don’t proactively ask their M&A intermediaries (business brokers or investment bankers) to anticipate expected fees on closing. Accountant and lawyer fees should also be estimated based on the deal complexity and progress. Regularly ask your advisors on their estimated fees and work in progress on the file to date. Don't let advisory fees become a surprise and sour your perception of the value that advisors bring to the deal.
- Advisory fees in this case are $1.5 million
Calculation of Net Cash Proceeds
Here is a summary of the net cash proceeds that our vendor would receive in our case study.
|Total Transaction Value||$25,000,000|
|Debt Free, Cash Free Adjustments
|Cash on balance sheet||$500,000|
|Repayment of debt outstanding||($2,000,000)|
|Purchase Price Adjustments||($300,000)|
|Net Cash Proceeds on Closing|
The $14.7 million at closing is quite a bit lower than the $25 million total transaction value that has been implanted in the business owner’s mind. I know this is a first world problem and many people reading this might laugh at the thought of the vendor being upset, but this issue is a deal killer in many instances. At the onset, what was believed to be a great deal becomes a bad deal once the details of net cash payment at closing becomes more apparent.
The issue is even more contentious when there are multiple shareholders to split the proceeds among. Let’s say that in our example there were five equal shareholders now receiving $2.94 million each. This is still a fair chunk of change, but, based on lifestyle expectations, may not be a sufficient amount for these shareholders to ride off into the sunset of retirement.
Anticipating the net cash proceeds on closing soon after an LOI is signed will bring more certainty and satisfaction to the vendors. It is an area of the transaction that requires significant and diligent attention.