Enterprise value and the price you receive: where the gap comes from

Two values not to be confused

Enterprise value measures what the business is worth, regardless of how it is financed. It is what you obtain by applying a multiple to EBITDA. It interests the buyer because it describes economic performance.

Equity value is what the buyer pays the shareholders. It is the enterprise value, less net debt and corrected by several adjustments.

The formula fits on one line:

Equity price = enterprise value, less net debt, plus or minus the working capital adjustment, less off-balance-sheet commitments.

An owner-manager who does not have this formula in mind negotiates on the wrong figure. He defends his multiple energetically for three months, then discovers on reading the sale agreement that most of the discussion was being played out elsewhere.

Net debt, broader than you think

Net debt is calculated as the sum of financial debts less available cash. On the face of it, a simple subtraction. In practice, both terms are the subject of tight negotiation.

What the buyer will want to include in debt:

• Bank loans, including the portion due within one year.
• Shareholder current accounts, unless it is agreed that they are repaid at closing.
• Finance leases and lease financing, restated as debt when EBITDA was calculated before lease payments.
• Provisions for retirement indemnities, often not booked in SMEs that apply the simplified method.
• Overdue tax and social security liabilities, overdrafts, factoring with recourse.
• Dividends voted but not paid.
• The cost of ongoing employment or commercial litigation, when it is not provisioned.

What he will contest on the cash side. Not all cash is available. A company needs a base to operate. The buyer will seek to show that the cash shown at 31 December is inflated by a seasonal peak in receipts, and that it is not representative of the average level over the year.

It is a legitimate argument, and it is also the one that costs the most money to sellers who do not anticipate it. The counter-argument is prepared with a monthly cash statement over three years, showing the real level and how it has evolved.

Normative working capital, the most technical line in the agreement

Working capital finances the operating cycle: inventories, trade receivables, less trade payables. It varies throughout the year.

The buyer wants to acquire a company with a normal level of working capital. If he receives a company whose customers have all paid and whose suppliers are still waiting, he will have to finance an immediate catch-up after closing. He will therefore ask for a price adjustment.

The mechanism is as follows. The parties define a reference working capital, calculated on a twelve- to twenty-four-month average. At closing, the actual working capital is measured. If it is below the reference, the price is reduced by the difference. If it is above, the price is increased.

Two points of vigilance for the seller. The first concerns how the reference is calculated: a rolling twelve-month average and an average over the last three financial years do not give the same figure in a growing business. The second concerns seasonality: a poorly calibrated smoothed reference for a company whose activity peaks in September mechanically produces an unfavourable adjustment.

For an SME with eight million euros in turnover, a ten-day difference in working capital represents around 220,000 euros. That is more than you gain by negotiating a tenth of a multiple.

The commitments discovered in due diligence

Some issues appear nowhere in the accounts and systematically surface during the audit. Each translates into a price reduction, a strengthened warranty or a condition precedent.

• Commercial leases. A change-of-control clause, an imminent expiry with no renewal secured, a rent well above market.
• Customer contracts. Termination clauses in the event of a sale, service-level commitments carrying penalties, unprovisioned year-end rebates.
• The owner-manager's personal guarantees. They must be released at closing, which requires the banks' agreement and sometimes takes several weeks to negotiate.
• Environmental liabilities. On an old industrial site, a soil survey can change the entire economics of the deal.
• Employment compliance issues. Undeclared overtime, poorly framed fixed-day arrangements, potential reclassification of self-employed contractors.

None of these points is a deal-breaker if it is identified early and dealt with. Discovered during the audit, they cost three times as much, because they erode trust as well as price.

A worked example, and what can be prepared

Services SME, 6.5 million euros in turnover, adjusted EBITDA of 700,000 euros, multiple negotiated at 4.5x.

The gap with the announced 3.15 million reaches 23%. Of this amount, a share is then deferred: escrow under the warranty and indemnity agreement, a possible earn-out. At closing, the owner-manager receives markedly less than the figure that had been circulating for six months.

Nothing in this table is abnormal or abusive. Everything in it is standard. The only anomaly would be to discover it at the moment of signing.

What can be prepared. Twelve to twenty-four months before: repay or renegotiate expensive debts, structurally reduce working capital by acting on customer payment terms and inventory turnover, book the retirement provisions so as not to suffer them in the audit, clear ongoing disputes. Six months before: build a monthly history of cash and working capital that will serve as the basis for the discussion on the reference, have customer contracts and leases reviewed to identify change-of-control clauses, document the EBITDA adjustments so that they are accepted without discussion.

What is no longer possible at the end of the road: emptying the cash through a dividend distribution just before closing. The buyer will see it, and the manoeuvre will turn against you in the definition of the reference working capital as much as in the relationship of trust.