cash free debt free basis? who pays off pre-transaction debt?

hello team. i am confusing myself badly and would appreciate your help here. 

example:

Buyer offers seller $1B TEV, cash-free debt-free basis. Seller has $200M of existing debt on the business and $100M in cash. 


So prior to or at close, seller uses the $100M of cash to pay down debt to now $100M. but then what happens to this remainder debt that the seller cant pay down yet? does the seller wait and use its proceeds POST CLOSE to pay that $100M of debt away? i imagine the buyer and lenders needs all that existing debt paid off before or at close. so in this situation, does the buyer divert $100M of proceeds to that lender at or before close so all the debt is paid off immediately? and the seller would just then get less proceeds (which were used by the buyer to pay down existing debt)? 

in the above scenario, seller would walk away with $900M cash ($1B - $100M from buyer to pay down remaining debt).


if seller had no existing cash, seller would walk away with $800M cash ($1B - $200M from buyer to pay down remaining debt) 


is this correct? which order of operations above is right? 


thanks team. 

 
Most Helpful

Let's use your example, $1B TEV, $200M of debt, $100M cash. Let's also assume the seller owes transaction fees of $50M and working capital at closing equals target working capital (the peg). Also assume buyer is funding entire transaction with cash and owes $20M of fees.

In the purchase agreement, there will be a section that outlines the closing proceeds to the seller. It will typically be computed as purchase price (TEV) + cash - debt - seller fees +- working capital adjustment. If closing working capital is higher than the peg, excess is increase to closing proceeds, and it is a decrease if opposite is true.

A funds flow will be prepared that schedules how money will be wired at close of transaction. In this example, the buyer will execute the following wires:

Closing proceeds to seller of $850M (see formula above)

$200M to holders of the pre transaction debt. Pre close, seller requests payoff letters from creditors that basically say, "if you pay me X by this date, the loans are satisfied and you have no further obligations to me"

$50M to each seller advisor / vendor for their services. Note this step will be multiple wires, one for each advisor invoice.

$20M to each buyer advisor / vendor for their services. Note this step will be multiple wires, one for each advisor invoice.

So, in total, buyer will have wired $1,120M, but net of the cash they acquired they are only out $1,020M (they bought a business with $100M sitting in the bank). This reflects the $1B purchase price plus the buy side fees.

Now, could the seller have distributed some of the cash and / or paid down debt prior to close? Sure, but the mechanics above would still hold.

Hope that clarifies.

 

Thanks boss man. Appreciate the color very much. Few follow-ups:

a) thank you for the detail. however, in my simple example (no transaction fees or anything like that), am i correct? 

b) i lose you when you say the buyer wires $1,120. i get the $1B purchase price... i get the $20M of buy-side fees... but why the $100M? for the cash in the bank? that confuses me. why would they wire $100M for cash the seller has? isn't this debt free cash free etc? 

 

This is an area that many juniors (and honestly even up to the Partner level) tend to either 1) model differently or 2) not align perfectly on. Personally, I think the issues lies with how all the LBO practice tests are formatted from BIWS etc.; its confusing.

In situations where there is some level of pre-trx cash & debt on the BS of the selling Company, in a cash free / debt free structure (most common), it's easiest to think about your EV (let's say $125mm ARR with a 8x rev multiple = $1B EV) as the purchase price. This EV will capture the net impact of the cash & debt balance (commonly referred to as net debt); no matter what, you as the PE buyer, are going to purchase the company at $1B. However, outside of core business value you're prescribing to the worth of the business, you also need to fund trx expenses & any NWC adjustment to the peg. So if we look at it from a simple "Uses" vantage point in a S&U table. What you need to remember is we are only worried about what WE as the BUYER is spending, not necessarily what the company does with those funds: 

Uses

Purchase Price: $1,000mm

Buyer Trx Fees: $20mm

Total Uses: $1,020mm 

If you want to expand this for more detail, we can show the impact of that cash & debt balance: 

Uses

Equity Purchase Price: $900mm ($1,000mm - $200mm + $100mm) 

Net Debt: $100mm ($200mm Debt - $100mm Cash leaves $100mm remaining to be paid off) 

Buyer Trx Fees: $20mm 

Total Uses: $1,020mm     

In both scenarios, the source of funds will typically be coming from some combination of PE equity & leverage. We have to "pay" for that extra $100mm in debt, but it's a pass through the company since it reduces their equity to shareholders in their own waterfall of distributions. If they had $0 in cash, shareholders would lose another $100mm. 

Where it can get really confusing is when there is a negative net debt balance (or no debt, extra cash). In these situations its best to have that work "off the sources & uses", the Company will distribute pro-rata the extra cash on top of what we are paying for the business as purchase price (in this case still $1,000mm).  

 

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I don't know... Yeah. Almost definitely yes.

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