The term Enterprise Value (EV) (1) is frequently used when discussing the valuation of a company. A widely used valuation multiple is EV / EBITDA (2).
EV represents the total value of a company including both its equity and its debt.
When someone says that he or she sold the business for $ 40 million, we do not have more information about the transaction unless we know what is the total amount of debt for that business. The EV is the holder of the purchase price in a negotiation. However, it is necessary to subtract the debt of the company to obtain the true Equity value. For example, if the business is sold for US $ 40 million, but has a debt of US $ 40 million, then the Equity value would be zero.
In one transaction, the EBITDA multiple does not mean anything in isolation
When valuating a business, is useful to calculate the EV and compare it with current and projected EBITDA and EBIT (3) and with net tangible assets. But in all cases and especially in companies with a low level of assets (such as those offering professional services) the EV should be compared to the free cash flow of the company. For asset-rich companies (such as construction companies) the EV should be also compared with future free cash flow and also with property, equipment, inventories, etc. When calculating the EV/ net tangible assets ratio, a high value indicates that a significant portion of goodwill is being paid for the business, leading to key questions such as how high goodwill is supported and why the EV is much higher than the value of net tangible assets. It may be because the business has a patent on a specific product or excellent relationships with its customers or a barrier to entry into a specific market. On the contrary, if these questions can not be explained, it is likely that the company is overpaying.
How transactions are structured by buyers
Just as EV is the total purchase price, it also affects how buyers structure transactions. Suppose a company with a recurring EBITDA of US $ 100 million is sold for US $ 500 million, which means that the EV/ EBITDA multiple is 5 times EBITDA. However, if the Company has US $ 200 million in priority debt, its equity value is US $ 300 million.
Here is a way in which a buyer would typically structure the transaction and how EV’s US $ 500 can be misleading. A private equity firm would inject US $ 200 million on a 50/50 equity basis and intermediate unsecured debt (4). The remaining US $ 100 million to constitute the equity value would be paid by allowing the previous owner to hold equity for US $ 50 million and issuing US $ 50 million in financing notes to the seller (5). The US $ 200 million of unsecured debt would be borne by the new buyer. Even if the EV is US $ 500 million and would be the owner of the transaction, the seller would receive “only” US $ 200 million in cash (funds injected by the private equity firm in the form of equity and intermediate debt). The retained equity and the financing given by the seller would total the other US $ 100 million as consideration other than cash and may have some associated risks. In the end, the holder of the transaction would be the EV of US $ 500 million but it must be considered that US $ 100 million of the equity value are assumed by the previous shareholder.
The cash “finally” paid is the actual measure
In short, sellers should pay less attention to a company’s EV and more to the cash balance they will receive once the transaction closes. It does not mean that the EV is not important, but this value can be misleading and does not necessarily translate into the equity value of a business or the cash you will receive for the sale of that business. As every business owner knows, that heritage can only be built over the years with a lot of effort.
(1) EV- Enterprise value
(2) EV / EBITDA Entrerprise value / Earnings before interests, taxes depreciation & amortization.
(3) EBIT- Earnings before interests and Taxes.
(4) Mezzanine debt refers to the highest risk debt whose repayment is subject to cash flow generation and is normally not guaranteed.
(5) Normally financing that the seller gives to the English buyer Seller note.