Selling a business is a complex endeavor. As advisors to business owners and shareholders of private companies, we have helped companies to navigate the process from beginning to end. We are excited to share those experiences and insights in this new series, “M&A Essentials.” The series will offer a fundamental understanding of the concepts, issues and processes every business owner should be familiar with when considering and conducting the sale of a business.
Today’s post discusses the relationships between a company’s valuation, purchase price and the cash proceeds received from a sale.
As shareholders consider selling a company, their primary financial goal should be to maximize the cash they receive over time for their investment. To estimate the cash flow of a sale transaction, it is critical to understand the fundamental elements of valuation, including enterprise and equity values, multiples and goodwill. In this post we will define these elements, explain their interaction and offer advice for those contemplating an M&A transaction.
What is Total Enterprise Value?
Total Enterprise Value (TEV) is the gross market value of a company and is synonymous with the transaction value of an M&A deal. The most common method of determining TEV is known as the Market Approach. Using this method, the TEV is calculated by taking a financial metric of the company’s annual revenues or EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) and applying a multiple. Absent a transaction, TEV is often calculated by estimating multiples based on valuations of comparable publicly traded companies or similar private company transactions.
How are Multiples Determined in an M&A Deal?
In the context of an M&A transaction, multiples depend on the valuations determined by prospective buyers and their assessment of the target company’s potential cash flow. The valuations calculated by prospective buyers yield an implied multiple based on their proposed purchase prices and the company’s EBITDA. Different categories of buyers have diverse motivations and expectations underlying their value perceptions. Strategic buyers are usually focused on returns relative to their own internal cost of capital. Their analysis often includes synergies, cost savings and opportunities for market expansion. Financial buyers, such as private equity groups, assess the cash flow potential of an investment with an objective of achieving a targeted rate of return on equity given a capital structure that includes both debt and equity.
How Does the Purchase Price Relate to Cash Proceeds?
Typically, purchase agreements exclude non-operating assets or liabilities, such as cash or interest-bearing debt, from the definition of the purchase price. Most agreements define the value of the transaction as the TEV, but the actual purchase price is an adjusted value reflecting that the sellers retain any cash at the closing but are responsible for the repayment of any debt remaining with the company. The language used in purchase agreements typically defines the purchase price as “debt-free” and “cash-free.” The reason for this methodology is that most buyers are interested only in acquiring the operating assets of the company (inventory, accounts receivable, property and equipment, etc.) while assuming its operating liabilities (accounts payable, warranties, etc.). These comprise the net operating assets that are employed to generate cash flow. (In addition, and as a practical matter, it is difficult for a buyer to assume bank and other debt when ownership changes).
Let’s look a hypothetical example of a company that is selling and evaluating a bid. Consider the transaction value presented in Exhibit 1. In this situation, a potential buyer has proposed a transaction value, or TEV, of $30 million based on their expectation of EBITDA of $5 million. Such a transaction implies an EBITDA multiple of 6 times.
In Exhibit, 1 we calculate an estimated purchase price due to the seller by deducting debt and adding cash shown in the balance sheet presented in Exhibit 2. Given a cash balance of $1 million and total debt of $10 million, a purchase price of $21 million is estimated. The purchase price is synonymous with a firm’s equity value, or the market value of the shareholders’ equity, in much the same way as a homeowner’s equity is determined by the home’s value less any mortgages due.
What Other Considerations Impact Cash Received at Closing?
Sellers also should consider other factors that may affect cash received at closing such as taxes and contingent payments, such as escrows, earnouts and seller notes. Also, most deals include a purchase price mechanism that adjusts the purchase price for events that cannot be measured until after the deal closes. When valuing an acquisition, buyers assume a minimum level of working capital to be delivered at closing. If the actual working capital is different from the target, the purchase price can be adjusted, up or down, as an equalization mechanism. For example, if a large unexpected payment arrives from a customer on the day of closing, thus converting a receivable to cash and resulting in less working capital being delivered to the buyer, a well-constructed mechanism would ensure that neither party benefits nor is harmed by such an event.
It is important to consider such mechanisms well in advance of final agreements — a bidder with a high working capital target may not offer as attractive a deal for the shareholders as another with a lower target. Many sellers have been surprised at the magnitude of post-closing adjustments, so it’s a good idea to track “cash at close” before the deal is consummated, and prior to and after closing.
How Does the Purchase Price Reconcile with Shareholder Equity?
Simply put, it doesn’t. You should notice the purchase price, or the market value of the equity, calculated in Exhibit 1 is well above the shareholder equity shown on the balance sheet in Exhibit 2. The reason for this difference is that buyers typically assign value to a company’s intangible assets, such as company reputation or intellectual property that is not reflected on the balance sheet. For any given bid or transaction, the difference between purchase price and book equity measures the premium a buyer is willing to pay over and above the book value of a company’s net operating assets.
Understanding the concepts and components of purchase price is the first step to better deal making. We will address these and many more issues in greater detail in future posts in this series.
Please contact Jim Lisy at jlisy@cohenconsulting.com for further discussion.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.