Debt-like items: buyer beware
Debt-like items can have a bigger adverse impact to expected returns than poor valuation
A few weeks ago, I posted some thoughts on calculating working capital. In that post, I used the analogy of purchasing a car to illustrate the need for a working capital target and subsequent true up.
One of the takeaways from that piece is that the sole purpose of a working capital adjustment is to align purchase price with the value of assets actually received. If we fail to perform the calculation correctly, we run the risk of receiving less value than we actually paid for.
Another way that we may potentially receive less value than we paid for is by failing to accurately flag and quantify debt-like items. These are not “long-term debt” as traditionally defined by generally accepted accounting principles; financial liabilities like term loans, revolving lines of credit etc. but they are similar to long-term debt in that they represent post-transaction uses of cash. They can be recorded in the financial statements or live off the books. Debt-like items are simply obligations to post-closing cash that arise from choices made by the buyer pre-transaction.
Identifying debt-like items during diligence is extremely important. In my experience, their appearance post-close is the most common source of drag to investment returns as opposed to poor valuation. The reason for this is that valuation, which should be approached as a range of values, can be highly subjective. Debt like items however are claims to hard dollars.
Here’s another way to think about them. The seller of a business made certain decisions and incurred obligations that gave rise to pre-transaction benefits. They have already received these benefits. Each dollar from your own purse that you use to extinguish these obligations instead of them is a dollar of purchase price.
If you are aware of these obligations and decide to proceed, that’s OK. The goal of the transaction after all is to give the seller purchase price in exchange for this stream of economic benefits. This purchase price can be delivered in many forms. The situation that you want to avoid however is the one where you believe you are investing $X in a business but inadvertently invest much more. This is surprise purchase price and that is the absolute worst form.
Many who might read this have heard the stories, perhaps had their own experiences. Soon after closing the surprise cash draws arise. Maybe the IT system isn’t up to snuff. Maybe the sales manager was promised a raise last year and you have to make good or she quits. In both cases, assuming your original purchase price reflected a going concern value and now you have to shell out more dollars to cure the issue, you’ve just paid additional purchase price. Even worse, what you pitched your investors as a 5.0x deal is really now 6.0x or more.
Identifying debt-like items
The most common reason debt-like items are overlooked is that they don’t often show up on the face of the financials. If your target has an annual audit, the footnotes may be a great place to look. In the lower middle market, this is uncommon.
Given the above, it is difficult to design a specific set of financial due diligence procedures to uncover them. You can however greatly increase your probability with a few best practices.
One way to identify debt-like items is to make sure you are active in supplemental due diligence streams, even if outsourced our outside your core competency. Most commonly, you you will flag a debt-like item when you hear something in one diligence stream that doesn’t comport with something you heard elsewhere.
For example, the CFO might have confirmed in financial diligence that no sales discounts have been granted during the past quarter. If your attorney notes on a call during contract review (which should encompass sales contracts) that she noted two contracts for bulk purchases at a discount, the alarm bells should go off.
It’s very easy to turn diligence into a check the box exercise. Especially in auction processes or deals with aggressive timelines. Approaching it holistically will help each work stream compliment the other.
Another way to identify a debt-like item is to ask redundant questions. In my experience, it’s not only important to continue asking the same question but to ask it to a lot of different people. Often times, someone won’t know an answer to a question and by human nature will tell you something that 1. doesn’t make them look bad or 2. just makes the most sense. This doesn’t make them a bad person. It just makes them human.
One way to hack this is by asking the same question to a lot of people to make sure their stories align. For example, you may want to know about the existence of purchase commitments. Ask the controller about it during your deep-dive into the financials. Then ask the operations manager about it during the plant tour. Then ask the AP manager when you take the accounting team out to lunch and the controller has gone to the bathroom.
Finally, another way to get better at identifying debt-like items is to get as many diligence repetitions as you can. The more reps you have, the more data points you have to reference as you hear folks make comments or see items in the financials that look odd. This doesn’t help a first or second time buyer so I’ve included a list of items below that are typically considered debt-like. This isn’t meant to be an exhaustive list but a few that are commonly found in the wild.
Treatment of Debt-like items:
If you identify a debt-like item, you can handle it in a few different ways. The first and most buyer-friendly is to make a direct purchase price adjustment. This is probably the best place to start. Particularly if it represents a claim to hard dollars’ post-close.
An example of an item where a direct purchase price adjustment is preferred is a transaction bonus for a key employee. This was clearly initiated for the seller’s benefit – executing a deal. As such, it should be their financial burden to bear. Again, the idea is that if you to pay this in their place you are giving them additional proceeds.
Another way to handle debt-like items is through a special escrow. An example of a debt-like item where this is appropriate is pending or threatened litigation. Say the target company is party to litigation that will be resolved within the year. You estimate that if the company loses the suit, it will be liable for $500K in damages. In this case, you might ask the seller to withhold $500K in proceeds in a special indemnity escrow to be release after one year. This is often a good compromise because you have strong downside protection should the worst case scenario materialize but the seller still has a path to full value should the suit be found frivolous.
A final option to consider is the use of specific insurance around representations within the purchase documents. Reps and warranties insurance is a special insurance policy that can be purchased to backstop specific representations made by the seller regarding the state of the company. For example, the company may represent within the purchase agreement that there are no outstanding escheat obligations or unclaimed funds. An insurance company may be willing to underwrite a policy covering this and other representations that will pay you should the representations be false. This may not be an option for buyers in the lower middle market and SMB space.
Folks reading this will know that treatment of items like these doesn’t occur in a vacuum. Getting a direct purchase price adjustment or additional escrow dollars isn’t always as easy as just asking.
My goal here is to help buyers become more diligent in identifying debt-like item so that they can pursue the best course of action in that particular deal. Again, the worst outcome is for a buyer to be surprised post-close. If you know about them, at the very least you can plan for it in your operating model. At best, you can come to an agreement with the seller to properly account for them in your valuation or structure.