Enterprise Value vs. Equity Value in M&A Deals: Understanding the Key Differences

When companies are looking to buy or sell, deal value is a crucial element in negotiations. And yet determining the true value of a company can be a point of confusion for both acquirers and sellers.

The key to understanding the value of a company lies in understanding the concepts of Enterprise Value (EV) and Equity Value.

• EV is a measure of a company's overall value, including both equity and debt.
• It's similar to the unadjusted "market value" of a house, which includes the outstanding mortgage and other costs.
• In simple terms, the headline number of an M&A deal, such as a £100 million purchase price, is not meaningful until the company's debt (and other adjustments) at the time of sale are known.
• The true cash price, or Equity Value, is determined by subtracting the company's debt (and other adjustments) from its EV (read on for more on this).

When an offer is made for a company as part of M&A, it's typically based on EV (the “headline number”). However, an offer will reference factors that reduce the headline price from EV to Equity Value (sometimes referred to as the EV equity value bridge).

Clearly, it's important for shareholders of the Target company to understand the true cash value they will receive from the sale. But many get confused (I’ve had to explain the concept to many selling shareholders in the past).

An easy way to think about the concept is to imagine a house purchase where the headline price is £1 million.

• A deposit of £200k is made, with the balance of £800k borrowed.
• The Enterprise Value (or ‘market value’) of the house is £1 million.
• The “equity value” the new buyer holds in the house is £200k – i.e., Enterprise Value of £1m (the “headline price”) less the £200k deposit.

Arriving at the true value of a company, or Equity Value, requires several adjustments to be made to EV. Every acquirer will have a different approach to determining EV, but it's often based on a multiple of EBITDA or revenue (this is a whole other topic!).

Typical adjustments that are made from EV to Equity Value include:

• Reduction for debt and other identified liabilities
• Increase for surplus cash belonging to the Target (if this is to remain on the balance sheet)
• Increase or decrease based on the variation in working capital at closing from a working capital target
• Redemption of any preferred stock, if applicable

It's common for both the acquirer and Target to agree that a deal will be predicated on a debt-free, cash-free basis, so that the acquirer doesn't inherit any debt and the Target doesn't leave any cash in the company without receiving value for it. Another assumption that's often made is that the Target will be acquired based on a normal level of working capital. However, determining what's considered "normal" can be contentious.

On deal completion, there may be conflicts between the acquirer and Target over how certain balance sheet items should be classified. These can include staff bonuses, derivatives, dilapidation costs and legal claims to name a few. Arriving at Equity Value can be a difficult and lengthy process, and the relative bargaining power of each party will play a role in how balance sheet items are classified (it’s not an exact science, although precedent often prevails).

It's important to note that arriving at Equity Value may be a difficult and lengthy process. High levels of cash and low levels of debt in the Target can make a deal significantly more profitable for shareholders, as they will receive not only the Enterprise Value but also the net cash in the Target. Conversely, high levels of debt in the Target can significantly reduce the value exchanged in a deal and make an initially attractive headline offer unappealing in reality.

Equity Value: Cash Adjustments

Cash is a separate asset to a company that can be easily removed without impacting the company's operations. This is different from other assets such as plant and machinery which would need to be replaced if removed by the seller. Shareholders of a selling company may choose to leave cash on the balance sheet and receive value for it by way of a premium over Enterprise Value.

• The usual reasoning for a seller opting to leave cash on the balance sheet is tax efficiency (depending on the tax jurisdiction).
• In determining the basis of the cash adjustment, “cash” needs to be defined. Careful analysis and consideration should be given to the nature of the cash in the Target.
• "Free cash" will usually be adjusted for in the final Equity Value on a £ for £ basis, making it in a seller’s interests to negotiate for the maximum amount to be designated as free cash.
• Cash defined as trapped may be excluded from the Equity Value or it may be applicable to redefine it as working capital and make an adjustment to the extent that it is higher or lower than normal.
• Some items that are not usually classified as “cash” on the balance sheet may be considered as “cash-like” for the purpose of Enterprise to Equity Value adjustments. Some examples include:

• Unutilised tax losses
• Cash arising on the exercise of share options
• Financial investments that will be acquired by the acquirer and realise cash at a later date.

Equity Value: Debt Adjustments

Many companies are financed through bank loans or other forms of debt. In an acquirer's offer, the "debt-free" assumption typically means that any debt in the Target will be deducted when arriving at the Equity Value, on a £ for £ basis.

• The debt adjustment will usually need to account for any redemption costs, accrued interest and gross-up of capitalised loan costs, which have reduced the stated debt amount on the balance sheet.
• An acquirer may be incentivised to treat items as debt-like given that this generates a £ for £ deduction to the Equity Value, whereas the seller will prefer them to be treated as working capital.
• The classification of items as debt or working capital can be a highly contentious issue between the acquirer and the seller. Factors to consider include:
• Whether the item was factored into the headline valuation
• The likelihood and timing of the item resulting in an actual cash outflow
• One key thing to note is that any debt items must be subtracted from Enterprise Value to avoid the acquirer having to settle these and additionally pay for them via the purchase price mechanism.

Equity Value: Working Capital Adjustments

A common assumption in an acquirer's offer is that the Target will have a normal level of working capital at the time of deal close. This assumption can cause an adjustment to the Equity Value if working capital at completion is not ‘normal.'

• If there is no working capital adjustment on a transaction it could present the following two problems:

• The seller may be incentivised to “manage down” the working capital, thereby increasing the upward Equity Value adjustment for cash, with no off-setting downward working capital adjustment.
• Deal close may occur at a high or low point in the working capital cycle, which could create a sub-optimal outcome for either the acquirer or Target.

• The two key considerations in determining the working capital target are:

• The definition or composition of working capital.
• Establishing what is a normal level of working capital for the business being acquired.

Preference Shares

When a company is acquired, the acquirer typically takes control of all common or voting shares. But what about preference shares?

• Preference shares are typically non-voting, so the acquirer doesn't have to redeem or buy them when taking over a company. Preference shares are common in a company that has taken in VC or PE funding.
• The terms of preferred shares should be described in the Target's Articles of Association and may include "tag rights" that require the acquirer to make an offer for all shares.
• Preferred shares can be "participating" or "non-participating" in distributions (participating preference shares are a type of preferred stock that gives investors the right to receive their preference amount first and then also a share of any remaining funds based on their ownership).
• If the Target has preferred shares, the acquirer may want to redeem them to avoid paying out dividends indefinitely.
• A "liquidation preference" is the amount that will be received for each preferred share upon a liquidation event, such as an M&A activity – understanding the implications here is key (when a company is sold, a liquidation preference may have implications for the seller by determining the amount of proceeds that each preferred share will receive upon a liquidation event, and potentially reducing the overall pay-out for the seller).
• When considering the redemption of preference shares, the acquirer may need to add the redemption value to the headline price (Enterprise Value) of the Target.

Worked Example

Enterprise Value (adjusted EBITDA x multiple) = £100m

Plus: surplus cash £20m

Less: debt (£15m)

Less: working capital deficit: (£15m)

Less: preference shares: (£2.5m)

NET ADJUSTMENTS: £12.5m

Equity Value = £100m - £12.5m = £87.5m

Takeaway

When it comes to buying or selling a company, deal value is often a point of great contention. The headline number of a deal value can cause confusion for both acquirers and sellers alike. But it's important to remember that the deal value outlined in an offer is typically based on Enterprise Value (EV) which represents the overall value of a company, including equity and debt.

However, this is not the final value that will be exchanged in a deal. To arrive at the true cash price, also known as Equity Value, adjustments will be made to account for factors such as debt and other liabilities, cash on the balance sheet, and costs of selling the business.

Here are a few key points to keep in mind:

• Enterprise Value is often referred to as a quick and easy way to estimate value, but it does not take account of capital structure.
• Equity Value, on the other hand, is typically used by company owners and current shareholders to help shape future decisions.
• An acquirer's offer on the basis of Enterprise Value will typically be based on the assumptions of the acquisition being on a "debt-free, cash-free" basis and subject to "a normal level of working capital."
• The Equity Value is the most important number for the shareholders of the Target because it represents the actual cash value they will receive after any adjustments to Enterprise Value.

About the Author

Tom is the CEO of Navima. Prior to Navima, Tom worked at 2 M&A boutiques (leading acquisitions, divestments, strategy and venture projects) and was Head of M&A & Corporate Development for a fast-growth, VC backed SaaS company. Tom has supported companies around the world including Shell, Unilever, Philips and the Big Four with improving their M&A process and leading the development of playbooks.