Debt-Like Items in Due Diligence: What Transaction Services Teams Must Catch

In most M&A transactions, the purchase price is calculated as enterprise value minus net debt. The definition of net debt drives the equity value the seller receives. Every dollar of debt-like items identified in diligence reduces the seller's proceeds.

This makes the debt-like items analysis one of the most commercially sensitive workstreams in financial due diligence. Miss a material item, and the buyer overpays. Over-classify, and the deal falls apart.

What Qualifies as Debt-Like

Debt-like items are obligations that function like financial debt but do not appear on the target's balance sheet as borrowings. They reduce the cash available to the equity holder and should be deducted from enterprise value in the purchase price bridge.

The SPA typically defines which items are treated as debt-like. In practice, the following categories appear most frequently:

Deferred consideration. Earn-outs, contingent payments, and deferred purchase prices from prior acquisitions. These are obligations that will require future cash outflows.

Unfunded pension obligations. The difference between projected benefit obligations and plan assets. This is a cash liability that will need to be funded post-close.

Tax liabilities. Unpaid tax assessments, disputed tax positions, and deferred tax liabilities that will crystallize into cash payments. Transfer pricing exposures are particularly relevant in cross-border deals.

Litigation provisions. Pending or probable legal claims where the financial exposure is estimable. The diligence team must assess both probability and magnitude.

Deferred revenue requiring future cost. When deferred revenue represents an obligation to deliver goods or services that carry costs, the net obligation may be debt-like. This is common in software, subscription, and services businesses.

Capital lease obligations. Under IFRS 16 and ASC 842, most leases appear on the balance sheet. However, the treatment in the enterprise value bridge varies by deal. Some SPAs include lease liabilities in debt; others exclude them.

Employee-related obligations. Accrued bonuses, deferred compensation, unused vacation balances, and restructuring-related severance. These are cash obligations that the buyer will inherit.

The Identification Process

Effective identification requires systematic review of the balance sheet, off-balance sheet commitments, and contingent liabilities. The standard approach:

1. Detailed balance sheet review. Walk every liability line item and assess whether it functions like debt. Challenge management's classification of current vs. non-current liabilities.

2. Off-balance sheet analysis. Review commitment and contingency disclosures, board minutes for approved but unrecorded obligations, and pending contracts with deferred payment terms.

3. Management interviews. Ask specifically about contingent liabilities, pending claims, and obligations not yet reflected in the financial statements.

4. Tax review. Analyze open tax positions, transfer pricing documentation, and correspondence with tax authorities.

This process depends on having clean, well-organized financial data. Teams that invest in financial data normalization early in the engagement can complete the debt-like items review faster because the balance sheet is already mapped to a standard structure.

Quantification Challenges

Identifying debt-like items is straightforward compared to quantifying them. Several categories involve significant estimation:

Pension obligations require actuarial assumptions about discount rates, mortality tables, and salary growth. Small changes in assumptions create large swings in the obligation.

Tax exposures involve legal judgments about the probability of assessment and the range of potential outcomes. The diligence team typically presents a range rather than a point estimate.

Litigation is inherently uncertain. The diligence team should assess the legal merits, potential damages, and timeline, then classify exposures as probable, possible, or remote.

For each item, the report should present a best estimate, a range, and the key assumptions. This gives the buyer a basis for negotiation and allows the SPA to address specific items through indemnities or escrow mechanisms.

Interaction with Net Working Capital

The boundary between debt-like items and net working capital is one of the most negotiated points in any deal. Items classified as debt-like reduce the purchase price directly. Items included in working capital affect the purchase price through the working capital adjustment mechanism.

The distinction matters because working capital is typically settled through a true-up within 60 to 90 days of closing, while debt-like items are deducted from closing proceeds. The financial impact on the seller can be identical, but the timing and mechanism differ.

Common boundary disputes include:

• Accrued bonuses: working capital or debt-like?
• Customer deposits: working capital or deferred revenue (debt-like)?
• Restructuring provisions: working capital or debt-like?

The diligence team should flag these classification questions early so they can be addressed in SPA negotiations rather than discovered post-close.

Reporting and Presentation

The debt-like items schedule is a key exhibit in the diligence report. It should include:

• Each identified item with supporting description
• Current balance and basis of quantification
• Classification rationale
• Interaction with working capital (avoid double-counting)
• Recommended SPA treatment

Clear presentation and thorough audit trail documentation strengthen the buyer's negotiating position and reduce the risk of post-close disputes. Items that are well-documented and clearly supported are harder for the seller's advisors to challenge.