One of the key financial elements in an M&A transaction is cash on the seller's balance sheet, that is, the amount of available cash the seller’s company possesses, which is reflected on their balance sheet. It is something that a buyer will review during financial due diligence, and it can have a significant impact on a company’s valuation. There are a number of things that sellers and buyers should understand relative to cash on the balance sheet.
Cash free, debt free transactions
Most M&A transactions involving technology companies are handled on a debt free, cash free basis. This means that the seller and the seller’s shareholders assume all company debt, but get to keep the cash listed on the balance sheet minus a certain negotiated amount that the buyer and seller agree is needed to continue running the company immediately after closing. A cash free, debt free transaction structure makes sense for most sellers because it is in their interest to get the maximum benefit of the excess cash in their business. That is why a cash free, debt free transaction structure is the norm for tech M&A deals.
As a seller you need to make sure that the Letter of Intent (LOI) or Indication of Interest (IOI) clearly states that the transaction will be structured as cash free, debt free. You do not want any misunderstandings to crop up during the M&A process regarding who gets the cash after the deal is closed. Misunderstandings like this can kill a deal.
Working capital
Buyers typically expect sellers to maintain a level of working capital sufficient for them to continue operating the business immediately after the acquisition. Working capital is simply the difference of current assets minus current liabilities. However, there can be major differences between what the seller and the buyer consider sufficient working capital. Sometimes it’s simply a matter of taking an average of the last 12 months of working capital. But other factors can make working capital a sticking point during negotiations. For instance, how will deferred revenue be treated? Will the seller leave cash in working capital for the buyer to fulfill any deferred revenue obligations? Is the deferred revenue going to be treated as debt, and if so, to what degree? How working capital will be calculated should be clearly stipulated in the agreement.
Note the cash is not usually included in the working capital calculation. But again, it’s important to clearly specify in the LOI how cash will be treated so the buyer and seller aren’t fighting about it before close.
Deferred revenue
Although the seller is responsible in a cash free, debt free transaction for paying all debts such as outstanding bills, loans, and other liabilities, there are some items that fall into this area, such as deferred revenue, whose treatment is often heavily negotiated between the seller and buyer.
Deferred revenue represents payments that the seller has received in advance for goods or services that have not yet been delivered ‒ for example, payments for future months of a software subscription. There are various ways that deferred revenue can be treated in a transaction. For example, it can be incorporated into the calculation of working capital. In this case, the deferred revenue is included as a current liability, but not called out separately on the balance sheet.
Or it can be treated as debt. If you treat deferred revenue as a debt, the amount the seller is responsible for should only be the cost to deliver the as-yet undelivered service, which in the case of software subscriptions is usually very small. It should not be the entire cost of the service itself. Calculating the cost to deliver SaaS as well as related services is critical to support your position in negotiations over deferred revenue.
Negotiations around deferred revenue are important. Consider what might happen if the seller's company receives a good portion of its revenue as pre-payments for annual contracts. They can have millions of dollars of deferred revenue. A buyer might then expect to get all of that revenue as cash to fulfill those obligations. So it's important that as a seller you understand what the buyer's position is regarding deferred revenue before you get into due diligence. You should get a clear agreement about the way it will be handled because you don't want any late surprises to jeopardize the deal.
Impact of cash on the balance sheet
If the transaction is structured as a debt free, cash free transaction, the seller gets all the excess cash. The mechanics of how that cash gets to the seller can have big tax implications. A seller might take a distribution from the company, either long before or at closing. Or the buyer might increase the purchase price by the amount of excess cash. Depending on the structure of the company (in the U.S., an S or C corporation), there can be a large difference in tax due on that cash.
It is generally not a good idea to keep a lot of unneeded cash in the business. A buyer might argue that it should be included in the working capital calculation to their advantage. At the very least, it makes sense to hold excess cash in an account labeled “excess cash” or “undistributed dividends”.
Get professional advice
There are many variables in every deal, such as the handling of excess cash, deferred revenue, and working capital. So it’s important that you get professional advice. This includes advice from a qualified tax advisor regarding tax implications. Also know that Corum has years of experience advising on the sale of more technology companies than any other firm in history ‒ an almost 40 year track record driven by a highly professional, detailed M&A process designed to get sellers an optimal outcome that includes maximized valuations, a properly negotiated transaction structure, minimized liability, and optimized taxes. So if you are considering selling your tech company, contact Corum. Their team of experienced dealmakers, all former CEOs who have run, sold, and bought companies prior to joining Corum, will advise and help you and your stakeholders achieve your optimal outcome.