Excess Cash in M&A transactions
The BIWS guide states that the acquirer doesn't pay for the target's excess cash balance during an M&A transaction. How does this make sense? Isn't the entire cash balance included in the purchase equity value?
Based on the most helpful WSO content, here's what you need to know about excess cash in M&A transactions:
Excess Cash and Purchase Price:
Equity Value vs. Enterprise Value:
Transaction Mechanics:
Practical Implications:
Example from WSO Content:
By understanding these distinctions, it becomes clear why the acquirer does not pay for the target's excess cash balance during an M&A transaction. The focus is on the value of the core business operations, which is best represented by the EV.
Sources: M&A Question Asked by PJT London, Confusion over Equity Value and Enterprise Value, What is paid for an aquisition - EV or Equity Value?, Acquisition Accounting I: Accretive (Dilutive) Deals Can Be Bad (good) Deals, Mistakes on WSO PE Prep Pack Models?
Because in effect they don't. Yes, they will end up wiring the seller more because of the value of the cash but they will essentially "make it back" by acquiring a business with that excess sitting there on the B/S. See cash free debt free basis? who pays off pre-transaction debt? | Wall Street Oasis top comment for an example with numbers.
Interview guides and prep materials play real fast and loose with "well you can just use the company's cash to pay off the company's debt" in a way that's not really how the mechanics work (and conceptually not the best way to teach "what is enterprise value" anyway, but I digress) in most deals.
Yea that makes sense. They pay for the excess cash and they get the excess cash back but one follow up I have is why this affects purchase price. If we define the purchase price as the amount the buyer pays for the seller, then this remains the same tho, right?
And yea in a cash free transaction where the target keeps the excess cash, it makes sense to me why the purchase price would be lower by the excess cash amount because the buyer simply doesn't pay for the cash nor do they get the cash.
Not quite because the seller actually gets more cash—remember that cash is an addition to equity value even though it doesn’t affect EV. Think about a seller selling a suitcase filled with 100 bucks of cash. They’d want 100 bucks to cede ownership, but the buyer would still have spent effectively nothing upon taking control.
Oh so we treat the excess cash separately from the seller? i.e. the purchase price is the amount required to acquire the seller with its minimum cash balance, not all its cash balance. Is my understanding correct here?
Let’s say in an M&A deal (transfer of 100% shares) where the Buyer & Seller agrees that TEV = $100MM. That number doesn’t move no matter what.
The question is: “How much will the Seller receive on the Transaction Closing date?” Each deal has different Purchase Price calculation mechanism, but the basic bridge is as follows:
Purchase Price (100% Equity Value) = Enterprise Value (which is fixed per above) - Net Debt + Delta of Net Working Capital (compared to a pre-agreed normalized level of working capital, but that is a different topic).
Net Debt = Total Interest-Bearing Debt + Debt-Like Items - Cash - Cash-Like Items (aka non-operating assets, like empty buildings not used in operation etc.)
The problem is with the definition of Cash. As you can see here, the Seller will try to maximize the Purchase Price, so they will argue that all Cash Balance should be included in the definition of Cash. On the other hand, the Buyer wants the opposite, so they will argue that the Minimum Cash Balance is Working Capital and only Excess Cash is “non-operating” and hence included in Net Debt.
Details such as these are not normally covered in guides. You need to work on live deals (especially during the SPA negotiation phase) to pick these up.
While a business is delivered cash-free, debt-free, this doesn't actually mean all the cash is swept by the sellers on the day before closing. Typically, you will incorporate this cash into a funds flow and the buyer will effectively pay for any excess cash (which can then be swept to paydown purchase price or kept to operate the business).
With that said, there's often a cap on how much cash can be delivered to avoid the buyer requiring incremental debt/equity to fund the cash, only to sweep it later. Taking it to an extreme, if a $200M EV business delivers $100M of cash, the buyer would need to go raise incremental equity/debt/fund line to pay for this cash, which obviously too wildly skews the capitalization. Therefore, you might say you'll pay for excess cash up to [$10M], etc.
Maybe in software businesses which I’m not familiar with. But generally that’s not how it works ij my experience (in theory nor practice). Normally you’d define what parts of the cash are working capital, trapped and freely available as part of your bridge to equity. Then you’d pay for all free cash. Then you estimate what you think freely available closing cash will be vs the balance sheet date. You indeed may need to overfund because of working capital swings but such is life. I don’t see why any seller would accept less cash than is freely available regardless of the number. This is the European method which may differ from the US method
You wouldn't underpay them on cash. You'd just force them to sweep the excess cash before closing on their own watch, rather than having to come out of pocket to pay them for the cash.
You can also get creative in the funds flow and use their excess cash to just pay the sellers or paydown the seller's debt, etc.
Think of it this way, you buy a car for $50K cash after you drive it home you found $10K in the glove compartment. What's the true cash-free / debt-free cost of your car? A good argument can be made it's $40K. While your immediate cash outlay is still the $50k, the net after your absorb the car (company) is $40k. That's why in transaction there's a true-up at the end via the Fund Flow adjusting for NWC, cash, and etc.
It’s not valued in EV as it’s a non-operating item but they do value it in Equity Value
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