Enterprise value vs. Equity value
A buyer’s offered enterprise value will typically be predicated on the following assumptions:
- The acquisition will be on a “cash-free and debt-free” basis; and
- The business will be acquired with a normal level of working capital.
This can be expressed as an Enterprise value to Equity value bridge, as shown below, which also illustrates the material impact these items can have on the final price:
From enterprise value to Equity value
|Enterprise value (€5 million x 8,0 multiple)||€40,0m|
|Plus free cash||€1,5m|
|Plus working capital on date of takeover||€12,0m|
|Minus normal level of working capital||(€14,0m)|
|Working capital adjustment||(€2,0m)|
The debt-free principle
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 from the purchase price on a Euro for Euro basis.
In addition to “debt”, the concept of “debt-like” items frequently arises on transactions. These are liabilities not taken into account in the headline enterprise value which can be considered as a balance sheet deficiency, even though they are not actually financing debt.
Debt-like items are a common area of debate and disagreement between buyers and sellers. A buyer may be incentivised to treat such items as debt-like given that this generates a Euro for Euro deduction to the equity value, whereas the seller will prefer them to be treated as working capital.
Examples of debt and potential debt-like items:
|Widely accepted as debt|
|Bank loans||Accrued interest||Related party loans||Financial leases||Corporation tax||Current accounts|
|Factoring debts||Transaction costs||Change of control costs||Deferred consideration||Overdue tax liabilities||Pension deficits|
|May be debt-like|
|Deferred revenue||Bonuses to be paid||Underspent CAPEX||Derivatives||Legal claims||Guarantee obligations|
Grant Thornton's research has shown that deferred income is the most debated value item in transaction price adjustments.
The classification of the above debt-like items as debt or working capital is highly subjective. Their treatment will depend on the nature of each specific item and will require careful analysis. The following considerations proof helpful when arguing as to whether or not an item should be viewed as “debt like”:
- Is the cost associated with the liability incorporated in the parameters used as a basis for determining the enterprise value or not (i.e. above or below the EBITDA)? If the cost is not taken into account for determining the Enterprise value, the debt should be deducted in order to arrive at the Equity value.
- What is the likelihood and timing of a particular item resulting in an actual cash outflow in the (near) future?
An area of frequent, and often material, disagreement are deferred income liabilities; where cash has been received in advance of recognising the income. The issue of deferred income is particularly pertinent to transactions involving technology businesses that apply a software subscription model with cash received in advance. This leads to a difference in timing between the moment the cash is received (as the case may be, before completion of the transaction) and the moment the good or service is delivered and the sales are recognised in the books (as the case may be, after the takeover date).
Buyers may take the view that this cash should be “left behind” by treating the deferred income as debt-like because the buyer will need to deliver the service and the business had not “earned” the cash under the seller’s ownership. Sellers may view this as a working capital item if it is a normal feature of the business’ cash cycle.
Again this issue must be considered on a case-by-case basis by assessing the fact pattern, including the cash cycle of the business. In some cases a compromise may be appropriate where an element of the deferred income is treated as debt-like and the balance as working capital.