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.
