TT288: DEBT FREE/CASH FREE share sales – Is it as simple as it sounds?
Most business owners will know that their businesses are generally valued by applying a multiple to their maintainable earnings – where the multiple reflects the risk of achieving those earnings. Therefore, the stronger the business, the higher the multiple used and the higher its value.
The increased use of EBITDA (the acronym for earnings before interest, tax, depreciation and amortisation) as a measure to determine the earnings of the business reflects its close approximation of the underlying ability of the business to generate cash. Albeit simplistic, this substitution of EBITDA (cash generation) for normal profit numbers allows the buyer to calculate a value for the business based on the discounted present value of future cash flows. It is though simplistic, as EBITDA does not take into account a number of factors which affect cash such as the need for capital expenditure and debt repayments. However, it does provide a ready reckoner of the ongoing cash generation ability of the business to fund the buyer’s repayment of their acquisition price.
Taken one step further and assuming the business has sufficient working capital on acquisition, then a business acquired on an EBITDA basis should then have sufficient cash to fund its ongoing and future operations. Therefore one might assume that any cash in the business at acquisition would be surplus as it would not be needed to run the business and thus reasonable to add this extra cash to the value of the business.
The opposite can also be assumed in that a company’s EBITDA would be insufficient to fund the repayment of any existing debt in the business (overdrafts, loans, invoice financing, HP obligations, corporate tax and overdue creditors). As a result, such debt would be deducted from an EBITDA based value in calculating the acquisition price.
Accordingly, a company’s value which is calculated using a multiple of EBITDA is then subject to an adjustment to move that value to a DEBT FREE/ CASH FREE basis.
Enterprise Value and Equity Value
The value calculated using a multiple of EBITDA is called the Enterprise Value. In simple terms, this is the value of the cash generating abilities of the underlying business of the company.
To calculate the whole company value or its Equity Value, the Enterprise Value is then adjusted for its debt and free cash and also adjusted for other company assets or liabilities which are not needed to support or run the underlying business. Commonly, these other assets would include investment properties or third party investments and the value of these assets would also then be added to the Enterprise Value to determine the company’s Equity Value. The aggregate of these adjustments is commonly referred to as the Equity Bridge – ie. The difference between the value of the business and the value of the company as a whole.
The Equity Bridge is therefore a very important component of any company value and is the part that often causes most price uncertainty to sellers as it is often not finally evaluated until just before or on completion.
The above is a simplistic explanation of the basic EBITDA valuation model which is then subject to many variables and complexities specific to individual businesses.
Here are some common issues that SME vendors may experience when faced with an EBITDA based valuation.
- Cash Free does not mean exactly what it says. The cash free amount relates to surplus cash only and it is only surplus cash which is included in the Equity Bridge – normal day to day cash requirements are assumed as being included within the Enterprise Value.
For instance an acquirer will want to be able to run the business after acquisition without any necessity to provide it with short term additional finance. So a seller with a VAT liability due 30 days after acquisition will be required by the buyer to leave sufficient cash to pay this bill and its other ongoing bills. A thorough Due Diligence exercise by the buyer will flush out the requirements for ongoing operating cash and thus seek to determine what is genuinely surplus cash.
The debate as to how much cash is surplus is also often hard fought with the seller arguing that most cash is surplus and the buyer arguing the opposite. A seller who is able to easily demonstrate what cash is actually surplus will often do better price wise than one that can’t. Depositing surplus cash in a separate bank account and showing that it is not then used to support normal operations is a very simple way of doing this. Looking at the company’s minimum cash balance across a 12 month period would also indicate that the minimum level of cash not used in that period is therefore surplus. Of course, the seller who efficiently operates their working capital cycle is also likely to have more surplus cash to increase their sale value.
- A Working Capital Adjustment always sits alongside a Debt Free/Cash Free mechanism. Again, this is an awkward area which is not well understood by most sellers. It is also an area which is left until late in the sale process before its impact on the ultimate sale value is understood. Indeed, its actual impact on the amount of free cash will not be calculated until completion.
A buyer’s requirement for a working capital adjustment is a fair one and is required to protect him from a seller artificially improving his cash position by unfairly manipulating his working capital cycle in the run up to completion.
At its simplest level, a seller may delay paying suppliers in the run up to a sale. The impact of this at sale is that the company’s cash will be higher at the expense of higher supplier balances. Without there then being an adjustment to correct this working capital imbalance, the seller will receive a higher price. Accordingly, part of the buyer’s Due Diligence will focus on establishing what the historic normal working capital requirement of the business is and will request an adjustment to amend the actual working capital on completion back to the normal amount.
The nature of a working capital adjustment will vary from business to business and each business should really understand its own working capital cycle, especially where the business may be subject to seasonal changes. Not understanding and taking such working capital fluctuations into account will impact upon the sale value depending on what time in the cycle a business is sold.
Of course, well advanced sale planning will help you create a more efficient working capital cycle and thus create as much free cash from your business as possible. Doing such planning late in the day will normally be wasted as a working capital adjustment will counter this, by adjusting free cash levels back to those based on its historic working capital cycle.
We hope that the above demonstrates that although the phrase CASH FREE/DEBT FREE sounds simple it is anything but that and is an area of the sale process which may prove very costly to the inexperienced seller or buyer. Early planning in this area is vital if you wish to create a solid business practise for managing your company’s cash flow as well as helping you maximise your sale value.
The above has been written to help simplify what is a complex area. If you require any further advice in this area or indeed have any questions about, please feel free to contact your Barnes Roffe relationship partner.
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