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A bridge too far – Part 1



Don’t let advisors bamboozle you on the fundamentals of the “equity bridge”


There is often a point late in the transaction that advisors get excited and encourage the buyer into an entrenched negotiating position on what is termed the “equity bridge”. They will duly explain that this is of vital importance to your consideration, and that the hardening of your stance will optimise your cash position. While there is indeed some truth to these statements, such a confrontational stance is often unwarranted and unhelpful and can sometimes lead unnecessarily to souring relations with the buyer in the final stages of the process. To better understand this important point I intend to use the next two articles to help sellers both de-mystify the “equity bridge”, and to understand that this is often merely the clarification and quantification of the offer previously negotiated and agreed upon.


Most offers for your company shares will be presented as an “Enterprise Value” which seeks to reflect the price required to acquire the business as a going-concern and is often calculated by using a multiple of the current year revenue or EBITDA. Valuing a business in this way allows competitive offers to be assessed on a comparative and simple basis. Any offer of an Enterprise Value will however be usually subject to both i) cash free, debt-free and ii) net-working capital adjustments. 


An “Enterprise value” which has been subjected to such adjustments is typically referred to as an “Equity Value”, and equates best to the value traded in publicly quoted stocks where the share value factors-in both the business value and its funding structure. It is this conversion from “Enterprise Value” to “Equity Value” which is referred to as the “Equity Bridge”.


The “Equity Bridge’s” importance is its connection between what the Seller perceives as the business value and what he ultimately gets paid by the Buyer – which depending on the specifics of the deal can either be higher or lower. The reason why this area can often be emotionally charged is that the Seller may quickly focus on a higher Enterprise Value, without considering the factors which will ultimately result in a lower Equity Value. It is perhaps human-nature, that having already spent the “Enterprise Value” in their head (or indeed their partner’s head), it often is a jarring awakening to be told that you will receive a sum significantly less.


This article will deal with the first part of the equity bridge “cash free, debt-free” which at its simplest means that when a buyer acquires, it is on the basis that the seller will pay off all existing debt and extract all excess cash at the transaction completion. 


Most deals are structured on this basis because of its reasonable assumption that the seller is fully entitled to any existing “excess cash” generated over and above the level of cash required to fund the on-going business (eg. payroll, creditor payments). It therefore equally follows that seller will be expected to settle any company “debts” which may exist at completion using the funds generated by the sale.


“Excess cash” is principally any cash held by the company being acquired that is in excess of normal working capital requirements. Cash held at bank or petty cash are perhaps the most common types although other balances such as rental deposits, short term investments can also be considered as cash or cash equivalent. 

  

“Debt” commonly includes any bank loans or overdrafts, shareholder or external loans, but can also include balances which buyers can reasonably argue to be “debt-like” such as outstanding corporation tax, accrued staff bonuses or deferred revenue.


It is in this area of “debt-like” items where negotiations can often become complex and can often lead to rising emotions as sellers feel that they are being screwed on the deal price. Many advisors will indeed go to battle with the buyers in a bid to prove their worth (and fees) and attempt to push back on potential debt-like adjustments to optimise the seller’s consideration. While it is difficult to be critical of any advisors attempting to fight for his client, it is also important to ensure that their arguments are based on equitable and normal market practice, rather than simply seeking to avoid the reduction of the equity value.


If we consider some typical examples : Outstanding corporation tax, it is equitable that since the seller receives the cash benefit of past trading, then he must equally bear the cost of the pre-acquisition tax upon these cash profits. Equity similarly dictates, that any staff bonuses which are accrued based on the pre-acquisition trading performance which have generated higher cash for the seller, should be a cost (and therefore a debt) to the seller. With deferred revenue, when a customer has prepaid the company ahead of work being performed, it is surely clear that this is a benefit for the company and not the seller himself. 


Despite the above examples appearing to have a clear and equitable solution, it remains the case that such points continue to be hotly contested by some advisors looking to leverage a better position. There are admittedly other areas such as employee gratuity balances, accrued holiday pay and dilapidation provisions which are less obvious and are based both on the market-practice in the transacting jurisdiction as well as the quantum involved. 


In all cases however, having a clear understanding of the buyer’s arguments and considering the equitable position using the broad principles of the equity bridge, will always assist the seller in resolving such issues and avoiding a strained relationship with the buyer. As such the earlier the seller identifies and discusses the cash and debt-like items with the buyer, the better and will always support a smoother negotiation. As has been discussed in earlier articles, both honesty and transparency as well as demonstrating a level of fairness will always place the seller in a strong negotiating position and can often be ultimately be more favourable in terms of the final consideration achieved.


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