Enterprise value defined
Most offers received for the acquisition of a company will refer to the enterprise value of the company. Enterprise value is defined as the value of a business on the assumption that it is cash free and debt free, and that it has a normal level of working capital.
Sophisticated purchasers will arrive at the enterprise value after carefully evaluating a number of factors, including the strategic fit of the business, the cultural compatibility, and most importantly the expected future financial performance of the business, including any post transaction synergies which they can bring. Often more than one valuation methodology is used to provide confirmation that the valuation is realistic and supportable.
As a shorthand, the most common way of phrasing an offer price for a company is in terms of the enterprise valuation as a multiple of EBITDA. However just because the enterprise value is expressed in terms of a multiple of EBITDA it does not mean that the enterprise value is calculated solely by multiplying the EBITDA by a valuation multiple. Valuation as a multiple of EBITDA is more commonly used as a guide, or as a reality check, or as a means of expressing a view on the quality of the business and its prospects than as a primary valuation method in itself.
Some pitfalls in expressing enterprise value as a multiple of EBITDA
There are certain pitfalls in using EBITDA multiples to express valuation which company owners should be aware of.
The EBITDA value used in expressing value as a multiple of EBITDA should be representative. To arrive at a truly representative multiple all one-off and non-recurring expenses, and any expenses which are not required in order to contribute to the profitability of the business, should be excluded.
Historic or projected?
The decision whether to use the historic EBITDA or the projected EBITDA will ofter depend on the nature of the business, the expected growth and whether you are the buyer or seller in the transaction. In companies which are growing strongly and which have a high degree of predictablity, then we recommend that sellers consider using projected EBITDA in their discussions.
Capital expenditure requirements
In some respects EBITDA value is used as a proxy for cashflow, but clearly it does not take into account the need for a business to invest in capital equipment. Therefore in a capital light business (such as services or many types of IT businesses) then the EBITDA might be a good approximation for cashflow, but in other sectors (e.g. manufacturing) there is usually on ongoing need to invest in the plant and production machinery. In addition, many businesses have cyclical capital investment requirements, with peaks in investment happening several years apart. This cyclical investment requirement is not captured in simply expressing valuation as a multiple of EBITDA.
Capitalisation of own work
In certain specific industries it is common practice for companies to recognise certain internally generated assets on their balance sheet. Most commonly this occurs with development expenses, especially in the IT sector, where a new software product is developed and the labour costs associated with its development are capitalised rather than expensed. The expense is thefore recognised in the income statement, not above the EBITDA line in the year when the cost was incurred, but in the amortisation charge below the EBITDA line, and the financial impact will be spread over multiple accounting periods. This often means that similar companies are not comparable as they have different policies about the capitalisation of development expense.
From enterprise value to equity value
For business owners, it is important to appreciate how the equity value is derived from the enterprise value. For illustration, let’s assume that a company makes an EBITDA of €5.0m and its owner has received an offer for his company which values it at €40.0m, or eight times EBITDA. The following table illustrates how the equity value will be calculated from the enterprise value:
Apart from the agreed normalised working capital, the value of each adjusting item in the above table is capable of being independently verified at closing. Both parties to the transaction should ensure that they have a clear understanding of a detailed breakdown of the company’s typical balance sheet and that the transaction documents are clear for example as to which balances are considered to be debt, and which balances are considered to working capital. For example, if a business has significant cash payments in advance, a purchaser may consider these to be debt like in nature, while a seller may consider them to be working capital.
Setting the target working capital
A common area of negotiation is how the normalised working capital should be calculated. Many businesses have significant seasonality, therefore it is common to use the target working capital by reference to an average of the normalised working capital in the business (i.e. excluding one-off and exceptional items) over a 12 month period.
As you may expect, there are certain matters which drive value which should be carefully considered when setting the agreed normalised working capital. Consider the following chart.
The chart shows a rapidly growing business which is set to be acquired at the end of a calendar year. At the year end the normalised working capital is €5.1m. In determining the agreed normalised working capital the seller of the business should seek to set the target as the average over the preceding 12 months which is €3.6m and which would therefore increase his equity value by €1.5m. In contrast, the purchaser would prefer to set the normalised working capital as the forecast amount required in the business in the first full year of ownership, which is €6.8m. This would therefore reduce the equity value by €1.7m. A compromise solution in this scenario would be to set the target using 6 months historic results and 6 months projected, which would be €4.9m, increasing the equity value by €0.2m.
Fixed assets in the transaction
Fixed assets do not typically give rise to any adjustments in the calculation of value. This is because they are generally required to generate the financial performance which is the reference point for the agreed enterprise value and therefore are not divisible from the value of the business itself.
However in some situations fixed assets can have a material impact on the transaction terms:
- You may find that a business has been starved of sufficient investment and that a significant capital expenditure programme is required immediately after the transaction in order to maintain the financial performance of the business. The potential purchaser may not have been aware of this while making its initial offer as the matter is only identified during due diligence. In this scenario there will typically be some intensive discussions about valuation with the potential purchaser seeking to either reduce the enterprise value, or to introduce an agreed adjustment into the bridge to the equity value to make up for the capital investment foregone. This scenario is most common when companies have been experiencing financial distress and have not had sufficient cash to renew their fixed assets.
- Conversely, if the company has recently invested in expanding its production capacity which is likely to generate additional revenue, or in automating certain processes which will result in material savings in production costs, then it should make sure that the enterprise value reflects this improved financial performance. If the seller has been working with advisors then they will usually have prepared a comprehensive set of financial projections which includes this improved performance and an information memorandum which explains the rationale behind the improved performance. However, if an unsolicited offer was received and the potential purchaser did not have access to this information then the seller is in a good position to negotiate better terms.
- Sellers should ensure that full value is obtained for all assets on the balance sheet. Purchasers are typically not motivated to pay fair market value for the land plot next door which the company has purchased just in case it needs room to expand in 5 years time. When we come across this scenario probably the most common solution is to spin off non-core assets into a new legal entity which does not form part of the sale process, therefore protecting any tax relief which the shareholders may enjoy due to the duration of ownership. Alternatively, the company should sell the asset at fair market value and any cash received increases the equity value realised.
If you are considering the sale of your business at some point, or if you are considering the acquisition of another company, then we would be happy to meet and explain some of the key considerations and the typical transaction value drivers to help you achieve the optimal transaction terms.