Does aggressively paying down debt increase my value?

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I was asked the other day if aggressively paying down debt prior to an ownership transfer would positively or negatively affect the valuation of a small closely-held company.  What a great question!  The answer: It will have no net effect on the seller. 

Here’s why:    If an asset deal is being contemplated, then by definition, debt is typically excluded from the deal.  Under this structure the purchase price is for only the assets of the business.  Debt is not transferred as part of the deal and remains the responsibility of the seller.  So, if debt were paid down in advance of the transaction by the seller, the seller would be responsible to pay down less debt with the proceeds of the transaction, retaining a larger portion of the purchase price.  However, how was that debt paid down?  By the cash flow of the business prior to the ownership transfer, or said differently, by the seller.  Since this cash would have effectively come from retained earnings prior to closing, the only difference is timing.  The net monetary effect to the seller is nil.   

Let’s look at a stock deal.  Unlike an asset deal, debt is typically transferred to a new owner in a stock deal with the purchase price adjusted based on the amount of debt assumed.  The seller’s net compensation however does not change.  If the amount of debt transferred to the buyer decreases prior to the transaction, the purchase price will increase as the buyer will be willing to pay more if they are responsible for less debt.  However, who paid down that debt in order to receive a greater purchase price?  The seller.  Had the seller chosen not to pay down and transfer all the debt to the buyer, the seller could have paid out those same dollars as owner’s compensation, dividends, or a capital distribution.  Once again, the net effect remains at zero.  The difference is timing and taxes.  Do you as the seller want to realize your benefit in the purchase price or through retained earnings?  It’s time to talk with your accountant to learn the tax treatment of each.