Why Enterprise Value Doesn't Tell the Whole Story About a Company's Worth
The enterprise value of a business always makes headlines, but this is not the actual cash the seller receives. Don't forget to subtract the debt!
If you are selling your business, it's smart to seek out someone who has done it before. The challenge is that sometimes entrepreneurs paint a rosier financial picture of the transaction. They may, for example, tell you that they sold for a huge multiple — but a multiple of what and when? Or they may tell you the total value for which they sold another business — without subtracting any existing debt.
So how can you determine what's really going on? The best way to properly separate myth from reality is to get a handle on what enterprise value is, how it's calculated and what affects the true value of a business.
Why Enterprise Value Is the Headline
EV represents the total value of a company including both its equity and its debt. If we were to compare the value of a business to that of a house, the EV would be the final sale price. However, when you sell a house, there is still a mortgage to pay out before you receive the net cash. The same applies for a business.
When someone tells you they sold their business for $40 million, it doesn't mean anything unless you also know the debt load. The EV is the purchase price headline you would hear about. However, you need to subtract the debt (just like you would a mortgage for a house) to get to the true cash equity value. If the business sold for $40 million, but it had debt of $40 million, then the equity value and the actual cash received would be nil.
The EBITDA Multiple Means Nothing in Isolation
You may hear that someone got paid 10x EBITDA for their business. This doesn't mean anything in isolation. What this means is that someone paid 10 times the estimated EBITDA the business can generate. Great, but there is much more to it. Is the multiple the right number? Is EBITDA reasonable?
When determining what your company is worth, calculate the EV and then compare it against trailing and forward EBITDA, trailing and forward EBIT, and net tangible assets. For all companies, but especially asset-poor companies (such as those that provide professional services), EV needs to be assessed against the company's free cash flow capabilities (EBITDA or EBIT are good metrics, but ultimately it is all about free cash flow).
For asset-rich companies (such as construction), EV should still be compared against future cash flows, but should also be checked against the asset backing of the equipment, inventory, etc. When computing EV to net tangible assets, a high ratio indicates that significant goodwill is being paid for the business. Then the questions would be what supports such high goodwill? And why is the EV so much higher than net tangible assets? It could be because this business has a patent on a specific product or excellent customer relationships, or a barrier to entry of a specific market. However, if the source of the goodwill can't be defined, then a high EV/tangible asset ratio could simply mean that someone is overpaying for the business.
How Buyers Structure Transactions
Since the EV is the total purchase price, it also drives how buyers structure transactions. Suppose that a company with a recurring EBITDA of $100 million is sold for $500 million. This means the calculated EV/EBITDA multiple is 5x EBITDA. However, if the company has $200 million of senior debentures, its equity value is really $300 million.
Here's a typical way that a buyer would structure this transaction and how the $500 million EV headline could be misleading. A private equity firm would inject $200 million on a 50/50 basis equity/mezzanine debt. The $100 million remaining to make up the equity value would be paid by allowing the previous owner to retain equity of $50 million and by issuing a $50 million unsecured seller note. The $200 million of senior debentures would be assumed by the new buyer. Although the EV is $500 million and would be the reported headline, the seller receives "only" $200 million in cash (the actual funds injected by the PE firm in the form of equity and mezzanine debt). The retained equity and the unsecured seller note totaling the other $100 million is non-cash consideration and may have some risk associated with it. The $500 million EV makes headlines, but consider that $100 million of this number is carried by the previous shareholder.
The Final Cash Paid Is the Real Measure
Ultimately, sellers must pay less attention to the enterprise value of a company and more attention to the actual check they receive once the transaction closes. This doesn't mean that enterprise value is not important, but rather that this value can often be misleading and doesn't ultimately translate to the value of the equity in your business. As any business owner knows, that kind of equity can only be built through years of hard work.