A key M&A concept to grasp is that transactions take place on a cash-free debt-free basis. This essentially means that the seller of a business will extract all debt and cash from the business prior to completion. This concept is illustrated through the enterprise value to equity value bridge (shown below).
The headline price of a business is typically based on a multiple of adjusted EBITDA (i.e. Earnings before interest, taxation, depreciation and amortisation; adjusted for any one-off income or costs and other normalisation adjustments). The multiple applied to adjusted EBITDA will vary depending on a multitude of factors such as perceived business risk, industry risk, potential synergies, expected growth levels and process competitiveness.
Enterprise value is the label applied to this headline price. However, enterprise value does not take into account the timing of the transaction. At any given point in time, the level of working capital or net debt within the business can fluctuate. Therefore, without making appropriate adjustments, the buyer would be getting a better or worse deal at varying points in time.
The equity value reflects the actual purchase consideration the buyer transfers to the seller upon completion. The enterprise to equity bridge calculation considers the timing of the business sale.
Net debt adjustment (debt-free cash-free adjustment)
Decisions to include or exclude balances from the net debt adjustment can be complex. Whilst some items are indisputable, other ‘debt-like’ or ‘cash-like’ items can become points of contention within negotiations.
Where there is cash in the business, it will generally result in a positive adjustment to equity value. However, prospective buyers must take care to consider only free cash. For instance, it would not make sense to apply a value adjustment for trapped cash that is stuck overseas where withdrawal restrictions or penalties apply. Other cash may be considered as more working capital in nature; for instance cash held within tills at retail locations. Another less traditional cash-like item could be a fixed asset held on the balance sheet which is not readily used in the business. Such a surplus asset could be assigned a value if that asset could be easily liquidated into cash proceeds.
In terms of debt; line items such as third party lending, corporation tax liabilities and bank overdrafts are often labelled as reported debt. However; similar to cash there are other considerations and potential debt-like items that can be included within the definition of debt. For example, accrued interest is often found within working capital in management accounts, but it is debt-like in nature and thus should be reallocated.
Other examples of potential debt-like items include:
- Transaction related liabilities such as professional fees
- Pension deficits
- Related party loan balances
- Bonus accruals relating to historical results
- Dilapidation provision
- Provision for legal claims
- If the potential buyer believes that the business has underspent on capex historically; capex spend requirements may be considered a debt-like item.
Working capital adjustment
The level of reported working capital in a business fluctuates on a daily basis. If no working capital adjustment was made to reflect a normal level of working capital in the business, either the buyer or seller may be on the receiving end of a poor deal. For instance, if lower than normal working capital was provided on completion, the buyer would need to inject more funds into the business than expected. Further; if no adjustment was made, sellers would be incentivised to reduce working capital (e.g. by incentivizing trade debtors for early payment or delaying trade creditor payments).
Reported working capital
Reported working capital will typically comprise stock, trade debtors, other debtors and prepayments, trade creditors, other creditors and accruals, and deferred income.
Normal working capital
Assessing a normal level of working capital can be one of the most controversial areas in purchase price negotiation. Adjustments will be pushed through on a monthly basis, to produce adjusted monthly net working capital figures.
Net working capital adjustments are often made to reallocate balances which are debt-like in nature, or to exclude non-recurring, one-off or non-trading balances. Example adjustments include:
- Deferred revenue where it is unusual or expected to unwind over a particularly long period.
- An insurance claim creditor which is not expected to reoccur should be stripped out of net working capital.
- Capital creditors are typically not considered to be non-trading in nature. If the business is particularly capital intensive, they may remain within net working capital.
- Creditor stretch pro-forma adjustment – if there has been noticeable creditor stretch leading up to locked box date, you may make a pro-forma adjustment to reflect normal credit terms.
- Adjustments to reflect appropriate accounting treatment. For example, bonuses are often only accrued at year-end within management accounts though in reality relate to the full year and thus should be built up over time.
The normal level is often then calculated as the average adjusted working capital for the preceding 12 months. A 12 month reference period is often chosen as it fully averages out monthly seasonal fluctuations. However; cases can be made for alternative reference periods. For example, in a fast growth business, it could be argued that a 6+6 forecast is more suitable (six months actual results plus six months forecast) as the working capital profile has significantly changed over the period. The choice of reference period can have a significant impact on equity value.