This article.has been written by Ravi Ranjan Singh, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho. It has been edited by Tanmaya Sharma (Associate, LawSikho) and Smriti Katiyar (Associate, LawSikho).
Table of Contents
Introduction
The fundamental financial aim of shareholders contemplating the sale of a firm should be to maximise the amount of money they get overtime as a return on their investment. The essential factors of valuation, such as enterprise and equity values, multiples, and goodwill, must be understood to predict a sale’s cash flow. The purpose of this essay is to identify these components, explain how they work together, and provide advice to individuals who are considering an M&A deal.
What is the total enterprise value?
It is the market worth of a company’s total assets that are used to calculate Total Enterprise Value (TEV). The Market Approach is the most often used approach for calculating TEV. By adding a multiple to the company’s yearly sales or EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), the TEV is computed this way. TEV is often computed in the absence of a transaction by extrapolating multiples from comparable publicly traded or private firm transactions.
Equity Value: All assets of the corporation are valued, but only by common equity owners – (shareholders).
Enterprise Value (EV): It is the value that ALL investors place on the company’s fundamental activities (equity, debt, etc.).
So, beginning with the equity value, compute Enterprise Value:
- If the items reflect additional investors or long-term financing sources (such as debt investors or preferred stockholders), they should be included in the list (Capital Leases, Unfunded Pensions)
- If the item is unrelated to the company’s primary business operations, remove it from consideration (side activities, cash or excess cash, investments, real estate, etc.)
What factors go into determining the multiples in an M&A deal?
During an M&A transaction, multiples are defined by the values set by prospective purchasers and their estimations of the target company’s future cash flow and profitability. Prospective purchasers’ appraisals provide an assumed multiple based on their acquisition prices and EBITDA (earnings before interest, taxes, depreciation, and amortization) of the firm. For various reasons and expectations, different types of purchaser’s value things differently. Strategic purchasers are frequently concerned with the return on their investment as it compares to their own cost of capital inside the organisation. They look for synergies, cost reductions, and new market possibilities as part of their investigation. The cash flow potential of an investment is evaluated by financial purchasers, such as private equity firms, to reach a specific return on equity in light of a capital structure that comprises both debt and equity.
What Is the relationship between the purchase price and cash proceeds?
The acquisition price is often not defined by non-operating assets or liabilities like cash or interest-bearing debt. Although the TEV is often used in agreements to describe transaction value, in reality, the purchase price is a recalculated value that reflects the fact that the sellers keep whatever cash they receive at closing but are still liable for any outstanding debt with the firm. The terms “debt-free” and “cash-free” are often used in purchase agreements to describe the purchase price. Since most buyers are mainly interested in acquiring a company’s functioning assets (inventory, accounts receivables, real estate and equipment, etc.), this approach makes sense (accounts payable, warranties, etc.). To create cash flow, these assets are used as net operating assets. Also, it’s difficult for a buyer to take on bank loans and other obligations when ownership changes.
Is there anything else that affects how much money I get in the end?
In addition, sellers should think about other things that might impact the amount of money they get at closing, such as taxes and escrows, earnouts, and seller notes. In addition, most negotiations contain a mechanism for adjusting the purchase price after the contract closes for occurrences that cannot be quantified. When calculating the value of a purchase, buyers believe the seller will provide a certain amount of working capital after closing. The purchase price may be modified up or down as an equalisation mechanism if the actual working capital differs from the objective. Suppose a substantial unexpected payment from a client occurs on the day of closure, turning a receivable into cash and reducing the working capital supplied to the buyer. A well-designed process would guarantee that neither party benefits nor are hurt by such an occurrence, for instance.
Considering these procedures well in advance of final agreements is critical; one bidder may not provide shareholders as good of a bargain as another with a lower working capital aim. Post-closing adjustments have caught many sellers off guard, so tracking “cash at the close” before consummation, as well as before and after, is a smart idea.
Components of purchase price allocation
- Net identifiable assets – The whole worth of an acquired company’s assets minus the total amount of its liabilities is known as net identifiable assets. It’s important to keep in mind that “identifiable assets” are things that have a definite worth at a certain period and whose advantages can be identified and adequately evaluated. The book value of assets on the acquired company’s balance sheet represents the net identifiable assets. You should know that identifiable assets might contain both physical and intangible assets, depending on your situation.
- Write up – A write-up is an adjusting increase to the book value of an asset that is made if the asset’s carrying value is less than its fair market value. The write-up amount is determined when an independent business valuation specialist completes the assessment of the fair market value of assets of a target company.
- Goodwill – Net asset value (assets fewer liabilities) is the difference between the acquisition price and the goodwill of the target company. Goodwill is calculated as the purchase price less the fair market value of the acquired company’s assets and liabilities.
An example of allocation of the purchase price
Company A just paid $10 billion for the acquisition of Company B. After the acquisition is completed, Company A, as the buyer, must apply current accounting principles to the purchase price allocation.
In the book, the assets of Corporation B are worth $7 billion, but the liabilities of the company are worth $4 billion. That leaves us with $3 billion as the estimated worth of Company B’s net identified assets.
Company B’s assets and liabilities were valued by an impartial company valuation expert, who came up with an estimate of $8 billion. To bring the book value of the company’s assets up to its fair market value, this conclusion means that Company A needs to record a $5 billion write-up ($8 billion – $3 billion).
Finally, because the purchase price paid ($10 billion) exceeds the total of the net identifiable assets and write-up ($3 billion + $5 billion = $8 billion), Company A must register goodwill. This means that Company A has to account for $2 billion of goodwill ($10 billion minus $8 billion).
The disarray
The issue is that many sites claim that Enterprise Value is what it “actually costs to purchase a firm.” This is not accurate. However, this isn’t always the case; certainly, Enterprise Value is occasionally more affordable, but this is dependent on the deal’s conditions and the Enterprise Value goods themselves. If you want to own 100 per cent of a corporation, you’ll have to pay 100 per cent of its common shares, we KNOW WITH ABSOLUTE CERTAINTY. This means that in an M&A transaction, the Purchase Equity Value acts as a kind of “floor” for the purchase price.
However, to arrive at the “actual price,” should you include the debt, preferred stock, and other financing sources of the seller and remove the whole cash balance?
In this article, we’ll focus on two of the issues with that strategy:
THE FIRST PROBLEM IS: Does taking on debt raise the price of a home?
Debt may be “assumed” (maintained) or “refinanced,” depending (replaced with new debt or paid off).
No increase in the amount the buyer “actually pays” the seller due to assumed debt. Cash is used to pay Off debt, which increases the amount paid by the buyer.
Replacing existing debt with the new debt: Increases how much the buyer “truly pays,” yet the buyer does not pay extra cash.
THE SECOND PROBLEM IS: Does paying with cash truly save money?
After purchase, a buyer cannot just “take” the full cash balance of a seller — all businesses need a certain “minimum cash level” to continue running, paying the bills, and so on. That sum of money is truly a vital asset for the company’s day-to-day operations.
For the sake of simplicity, we disregard the minimum cash requirement and instead deduct all cash from the total. Hence, even in an M&A transaction, a firm running on its own always needs a certain minimum amount of capital.
Complications of Other Sorts
The buyer will always have to pay transaction fees; they’re always there (lawyers, accountants, bankers, etc.).
For example, unfunded pensions, capital leases, and other types of obligations are sources of concern. Change of control doesn’t necessitate payment or repayment of these, Consequently, even though they are included in Enterprise Value, they may not affect the price.
Consider the possibility of using both buyer and seller cash to finance a transaction. Therefore, the actual amount paid could not even be close to the equity value or enterprise value of the seller.
The verdict
A company’s “value” must be distinguished from the ‘actual price paid.’ When it comes to valuation, Equity Value and Enterprise Value are helpful. However, they aren’t as helpful when trying to figure out what a company is worth.
It depends on the conditions of the agreement whether the true price paid is between the Equity Value and Enterprise Value, above them, or even below them — owing to the handling of debt and cash, fees and obligations that do not affect the cash cost of making the deal.
Language like “Including the assumption of net debt” refers to the estimated Purchase Enterprise Value, which is calculated as Purchase Equity Value + Debt – Cash, in the transaction agreement.
However, it does not reflect the price paid by the buyer; rather, it is a method for valuing the transaction and obtaining multiples such as EV / EBITDA.
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