From Enterprise Value to Equity Value
In simple terms, Enterprise Value (EV) is the total value of the company which includes its equity and debt. To arrive at this value, a pricing multiple is applied to the earnings before interest, tax, depreciation and amortisation (commonly referred to as EBITDA). However, from an M&A standpoint EV does not represent the ultimate value which the Seller receives from the sale of its business. It is just the headline or indicative price which the Buyer sets to entice the Seller and does not consider any adjustments. Instead, Equity Value plays a more important role as the same represents the actual cash the Seller would receive after making requisite adjustments to the headline EV. So How do we get from Enterprise Value to Equity Value A headline EV is often based on the assumption that the acquisition will be on a cash free or debt free basis and subject to a normal level of working capital. This is often referred to as the EV to Equity Value bridge. Let us look at a simple example:
- Cash on Balance Sheet: To the extent that there is cash in the business, it will usually trigger an upward adjustment to the equity value unless the Seller plans to extract it on Completion. This adjustment enables the Seller to benefit from Surplus Cash still within the business, which has accumulated under their ownership. If this adjustment was not made, it would be seen as a nice ‘windfall’ for the Buyer over and above the valuation. In order for the Seller to be compensated for surplus cash left behind, it will need to be demonstrated that this cash is “free cash” as opposed to “trapped cash”. Trapped cash could be cash required to be ring-fenced for regulatory or contractual reasons or cash held on behalf of customers or clients.
- Debt on Balance Sheet: Many businesses are financed through bank loans or other forms of debt. The ‘debt-free’ assumption in a Buyer’s offer will typically mean that any debt in the target will be deducted when arriving at the equity value, on a euro for euro basis. If this wasn’t the case, the Buyer would have to fund and service the debt, which would normally be a cost over and above the EV. Loans are often repaid on completion of a transaction, as the buyer will usually have its own funding structure to put in place going forward. Items like bank loans, accrued interest, break costs, overdrafts, finance leases are widely accepted as Debt.
- Normalised Working capital adjustment: A common assumption of a Buyer’s offer is that the business will have a normal level of working capital. This assumption will trigger an adjustment to the equity value to the extent working capital at completion is not ‘normal’. If there is no working capital adjustment on a transaction this could pose the following two problems:
- Sellers may be incentivised to manage down the working capital (e.g., delaying a supplier payment), thereby increasing the upward equity value adjustment for cash, with no offsetting downward working capital adjustment and
- completion may occur at a high or low point in the working capital cycle. This could be due to working capital seasonality or due to the timing of payments and receipts around completion. Again, this would result in a cash swing and adjustment, with no offsetting working capital adjustment, which could create a less than ideal outcome for either party.
- the definition or composition of working capital and
- establishing what is a normal level of working capital for the business being acquired.