In middle-market M&A, the treatment of debt is often one of the most critical yet misunderstood aspects of transaction structuring. While enterprise value determines the gross consideration, how debt and debt-like items are defined and settled can materially affect negotiations, closing mechanics, and ultimately the economic clarity of the deal.
Misalignment between buyer and seller on what constitutes “debt” – from capital leases and accrued expenses to deferred revenue or off-balance-sheet obligations – can lead to last-minute friction, valuation disputes, or even jeopardize closing. A disciplined approach to identifying, quantifying, and agreeing upon these adjustments early in the process is essential to preserving deal certainty and avoiding post-closing surprises.
Here’s a practical guide to how loans, leases, and other liabilities are treated in a business sale – and how thoughtful planning can help you avoid last-minute complications.
1. The Big Picture: “Cash-Free, Debt-Free, and Normalized Working Capital”
Most middle-market transactions are priced on a cash-free, debt-free basis and assume a normalized level of working capital at closing. In practice, this convention ensures that buyers acquire the ongoing operations of the business – its earnings power – without inheriting the seller’s capital structure or cash reserves.
The purchase price is therefore adjusted for net debt and deviations from target working capital (NWC) to arrive at the final equity value. The formula is straightforward:
Equity Value = Enterprise Value – Debt + Cash ± Working Capital Adjustment
While the enterprise value reflects the total value of the business on a cash-free, debt-free basis, the working capital adjustment reconciles short-term assets and liabilities to ensure the business is transferred with a sustainable level of liquidity. This prevents sellers from “harvesting” cash or deferring payables before closing and protects buyers from having to inject additional capital post-transaction.
Defining the working capital target – typically based on a trailing twelve-month average adjusted for seasonality or growth – is one of the most important and frequently negotiated elements of deal structuring. A disciplined approach to setting and testing this target early in the process minimizes post-closing disputes and preserves the integrity of the purchase price.
In simple terms:
- Buyers pay for the operating value of the business, not its cash or its debt.
- “Net Debt” includes not only bank loans but also debt-like items such as unpaid taxes, accrued bonuses, customer prepayments, and other long-term obligations not part of NWC.
- Sellers use sale proceeds to settle these obligations and retain the remaining equity value.
Example: A $20 million purchase price with $5 million of net debt results in $15 million to the seller, before transaction costs and any escrow and NWC adjustments.
2. Two Common Deal Structures – and Why Debt Treatment Differs
Asset Sale: In an asset sale, the buyer purchases selected assets and takes on only specific liabilities.
- Debt Treatment: Unassumed debts – like bank loans or tax liabilities – stay with the seller, who typically repays them at closing.
- Buyer’s Benefit: A clean slate with limited exposure to unknown liabilities.
- Implications for Seller’s: More post-close cleanup, but greater flexibility in what’s included – for instance, retaining certain real estate or legacy contracts that don’t fit the buyer’s needs.
Liabilities buyers may assume:
- Trade payables tied to operations
- Certain leases (with landlord consent)
- Assigned customer contracts and warranties
Liabilities sellers usually settle before closing:
- Bank lines, term loans, and capital leases
- Tax liens and overdue payroll or sales taxes
- Litigation or environmental obligations not expressly assumed
Stock Sale: In a stock sale, the buyer acquires the company’s shares – taking ownership of both assets and liabilities.
- Debt Treatment: All obligations remain within the entity. The buyer effectively assumes them.
- Economic Adjustment: The purchase price is reduced for net debt at closing, ensuring the buyer pays only for equity value.
- Protection: Buyers rely on representations, warranties, indemnities, and sometimes representations and warranties (R&W) insurance to manage post-closing risks. R&W insurance also helps reduce escrow amounts and speeds up resolution if issues arise.
3. What Counts as “Debt” or “Debt-Like”?
Beyond traditional loans, buyers examine “debt-like” items that represent future cash outflows, including:
- Accrued but unpaid expenses (bonuses, commissions, PTO)
- Unfunded pensions or deferred compensation
- Customer deposits or prepayments
- Unpaid taxes or payroll liabilities
- Shareholder loans or related-party balances
- Contingent liabilities (litigation, regulatory fines)
Tip: Define “Net Debt” and “Debt-like Items” clearly in the LOI. Closing-day surprises around these definitions are among the most expensive mistakes in M&A. In some cases, buyers and sellers may agree to set aside specific reserves for uncertain obligations like litigation or tax disputes. Complex exposures may even be placed in a litigation trust or escrow account to ensure liabilities are properly funded post-close.
4. Handling Specific Debts: Common Scenarios
- Revolver or Credit Line: Paid off at closing; lenders issue lien releases.
- Term or Equipment Loans: Repaid with sale proceeds; obtain payoff letters showing per-diem interest.
- Government-Backed Loans: Confirm transferability or repayment rules; often must be cleared pre-close.
- Leases: Capital leases are typically treated as debt; operating leases are usually assumed or factored into working capital.
- Seller Notes or Earnouts: Usually repaid, renegotiated, or included as debt-like obligations.
5. Bridging Enterprise Value to Equity Value
A typical transaction bridge looks like this:
- Enterprise Value (EV) – headline price
- Minus: Net Debt
- Plus/Minus: Working capital adjustment (vs. target)
- Minus: Other debt-like items
- Minus: Seller-paid transaction costs
= Equity Value (what the seller actually receives, net of escrows or holdbacks)
6. Common Transaction Scenarios
- Asset Sale with Paydowns: Seller clears all debt; buyer assumes select payables and contracts.
- Stock Sale with Escrow: Buyer takes the entity; price adjusts for net debt; escrow covers post-closing risks.
- Carve-Out: Parent retains some liabilities; intercompany balances are settled via a transition balance sheet.
- Highly Leveraged Seller: Most proceeds go toward debt repayment – making lender releases and fee negotiations critical.
7. Strategies to Manage Liabilities Before a Sale
- Clean the balance sheet early: Resolve small loans, unpaid taxes, or liens well ahead of closing. Also review asset accounts – reconcile old receivables, write off obsolete inventory, and ensure values are supported by documentation.
- Define key terms in the LOI: Include a sample Net Debt and Working Capital calculation.
- Align on working capital peg: Use seasonally adjusted averages and agree on inclusions.
- Line up payoff letters: Get lender confirmations and lien releases in advance.
- Use escrows and R&W insurance wisely: They help bridge risk gaps between buyer and seller.
- Choose the right structure: If liabilities are messy, an asset sale might be cleaner; if continuity matters, a stock sale could be simpler.
- Model the funds flow: A clear sources-and-uses schedule prevents confusion on closing day.
| Sources of Funds | Uses of Funds | ||
| Purchase price | $50 M | Debt repayment | $15 M |
| Seller cash | $1 M | Transaction costs | $2 M |
| Escrow | $1 M | ||
| Net proceeds to seller | $33 M | ||
| Total | $51 M | Total | $51 M |
8. Quick FAQs
Q: Do I have to pay off all debt before selling?
A: Usually, yes. In asset sales, buyers won’t accept liens; in stock sales, the purchase price is adjusted for net debt anyway.
Q: Are leases considered debt?
A: Capital leases generally are; operating leases affect working capital and may need consents.
Q: Can the buyer assume my debt?
A: Sometimes, but the buyer will adjust the price accordingly – and still require lender consent.
Final Takeaway
In both asset and stock sales, debt plays a central role in determining the seller’s net proceeds. Most deals are structured so the buyer acquires a debt-free business, with sellers using sale proceeds to pay off obligations.
The key to a smooth closing?
Start early, define terms clearly, and maintain a transparent balance sheet. When debt, working capital, and cash adjustments are well-documented, both sides can focus on what matters most – a fair deal and a clean handover.
At Harney Capital, we help business owners understand the funds flows and the net proceeds generated from a sale – factoring in every form of debt, lease, and working capital adjustment – so there are no surprises at closing.
