Usually, people work as either a self-employed individual or an employee for a business. Nevertheless, there...
If you own a business, you may consider selling it at some point. If you do, the key figure you will be interested in is how much you will receive from the sale.
However, the figure quoted in the contract may not be the amount you eventually receive so it is essential to understand how the price is calculated and any deductions which could be made.
To do this, you will need to know the difference between enterprise value and equity value, and the impact they have on your eventual sale. It is a complex area as the two figures have some similarities; this guide explains the basics of each and how to use the information.
The Need For Both Enterprise And Equity Values
It may seem unhelpful for a business to be valued in two different ways, but both enterprise and equity values provide useful information. This may seem confusing at first but, providing you understand how to use each respective figure, the extra insight can be invaluable.
In high-level terms, the enterprise value of a business is calculated by using key elements of financial performance. In contrast, the equity value is the amount that a buyer will physically pay once they have adjusted the equity value to take into account factors such as working capital, debt and cash.
When an offer is made, it is usually the enterprise value which is quoted but when the sale completes, it is the equity value which is paid. As a seller, if you are not aware of the difference, you could receive a nasty shock on completion.
Buyers typically use the enterprise value when they make an offer because it appears more attractive to the seller. When you accept an offer, it is essential to be clear about whether you are agreeing to an enterprise value or an equity value. It is normal practice for an enterprise offer to be made, and then the figure adjusted throughout the negotiations to reach the equity value which will eventually be paid.
Neither the enterprise value nor the equity value has any use for tax purposes. This is an entirely different calculation which takes different financial factors into account.
Now that we have explained the basic difference between equity and enterprise value and when they are used, we are now going to look at each one in more detail.
Enterprise Value
Put simply, the enterprise value is the total value of all the assets which are held by the business. Cash or debts are not included in the calculation and the funding structure of the company is disregarded for the purpose of the enterprise value.
Arriving at the enterprise value typically includes using various financial performance indicators such as Discounted Cash Flow (DCF), Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA), Earnings Before Interest and Taxes (EBIT) or alternative methods, e.g. gross sales multiple.
One of the reasons that enterprise value is used is that it makes it possible to compare companies that have different financial structures, making it a useful tool to use.
Equity Value
The equity value is calculated by taking the enterprise value plus cash and debts into consideration. If you know these three figures you can calculate the equity figure for yourself:
Enterprise value plus cash minus total debts equals equity value
A good way to explain equity and enterprise is to use the analogy of purchasing a house. The enterprise value is represented by the value of the property. The equity value is represented by deducting the outstanding mortgage from the value of the property. Obviously, this is a simplistic and pared down example, but it illustrates the differences between the two figures.
There may also be an adjustment to the equity value due to working capital (see below). This could be a plus or minus adjustment.
Cash Free, Debt Free Sales
If you are selling a business, as well as understanding the enterprise and equity figures you will also need to be aware of cash free, debt free sales. This is another element which will have a bearing on the amount of money you are eventually paid.
In cash free, debt free sales, the seller is obliged to take out all of the company’s cash and pay off any debts prior to completion. In theory, this sounds like an easier way for the sale to proceed but in practice it is not always possible.
Therefore, if a cash free, debt free sale has been agreed, there will normally be changes made to the purchase price to reflect the fact that cash has not been taken and/or debts not been cleared. The adjustments will be made pound for pound, calculated on the exact amount of debts and cash.
There is not a single universal clear definition of what is included in a company’s cash and debt figures so this must be agreed at the outset.
Cash would typically include petty cash, cash held in escrow, card payments or money in transit, rent deposits and cash in any bank accounts.
Debts normally include shareholder loans, finance, bank loans, overdrafts, declared but unpaid dividends and long-term debts.
Working Capital
An allowance for working capital is often included in the cash free, debt free calculation. This is because if the seller removed all of the cash (as defined above) from a business, it may be difficult to continue operating. Making an allowance for working capital means that the cash free, debt free model can still be used while still allowing the business to operate without interruption.
The working capital is typically agreed fairly early in the process but can be adjusted close to the completion date if there is a significant difference between the planned target and the actual amount.
There are different models for calculating an appropriate amount of working capital and what you use depends on the type of business. Twelve months may be an appropriate amount of working capital for many businesses, but if there are marked seasonal peaks and troughs, a different amount may be needed to cover the extremes of trading.
If you have any questions about the issues raised in this article, we at Key Business Consultants can help. Get in touch with us today or call us directly on 020 3728 2848.
