According to the classic approach, the value of a product or service is the amount that the market is willing to pay for it. In essence, this is also true for businesses, with the adjustment that in this case, the level of demand and the price offered are not determined by the benefit provided by the product or service, but essentially by the trust in the company’s future, its ability to create value, work profitably and grow. Translated into the language of numbers, these capabilities, represent the company’s future cash flow (apart from other values).
After the above textbook-like introduction, let us see how all of this looks like in real life? What are the main indicators that can serve as a good starting point for estimating the value of my business? What do the terms normalised EBITDA, net borrowings or reference working capital mean? If we are not aware of what is behind these few financial indicators, we are like the captain of the ship who asked his engineer:
“How much?”
“24,” the engineer answered.
“What is 24?”, the captain asked.
“Why, what is how much?!”, the engineer replied back.
Therefore, we should be aware what the different indicators – which determine value of the company – mean, how we calculate them, and what opportunities we have to maximise the value of the business offered for sale. When going into the negotiations, we should be prepared that the buyer and its advisers will contest the financial indicators underlying the value in every possible way during the due diligence procedure, in order to lower the purchase price. Therefore, it is very important that we understand these indicators, know at least their approximate meaning, and communicate them in the appropriate way to the buyer (we can leave detailed knowledge to our financial advisers).
In business, the simplest and most commonly used method of valuation is linked to normalised EBITDA (Earnings Before Interest, Tax, Depreciation and amortisation) as a financial indicator:
- The company’s annual normalised EBITDA and a market multiplier characteristic of the given industry and geographical location can be used for a first approach to determine the value of the business. This brings us to the so-called “cash-free debt-free” company value.
- The company value estimated in accordance with the above needs to be corrected by the balance of the company’s borrowings and liquid assets (net borrowings) in order to calculate the value of the company’s equity.
- Finally, the purchase price will also reflect the company’s working capital position. In order to maintain the EBITDA serving as the basis of the valuation also in the future, the company must continuously provide working capital.
To sum up, we can calculate a company’s purchase price as follows:
Purchase price = Cash-free debt-free company value -/+ Net borrowings +/- Working capital position
Next, let us consider what these elements mean exactly and how can we calculate them?
Cash-free debt free company value
Calculation: annual normalised EBITDA x market coefficient.
At least two questions may arise concerning normalised EBITDA:
- What method should we use to calculate it,
- What period should the EBITDA value be based on?
I. The starting point for normalised EBITDA is the reported EBITDA (as presented in the annual profit and loss account), which we modify by the following items, among other things:
- one-off, non-recurring expenses, revenues (e.g. grants, sale of tangible assets, etc.);
- non-business related expenses/revenues (e.g. owner’s personnel costs);
- transaction related expenses (legal fees, consultancy fees, bank charges);
- items not posted for accounting (e.g. employee benefits outside the accounts and the public charges on these).
II. Which period should we use for the EBITDA?
The decision on this depends on the agreement of the parties. In “peacetime” (i.e.pre-Covid), the reference period was the past 12 months in case of approximately 2/3 of the transactions, while in the the remaining 1/3 of the cases some other period (e.g. the past six months annualized, or the past 6 months and the planned next 6 months, or the planned next 12 months) was used. The current business outlook predominantly considers the effect of Covid as a one-off factor, i.e. the pre-Covid EBITDA values are used for the determination of the normalised EBITDA.
The Seller’s aim: to show as high a normalised EBITDA as possible (highlighting costs, expenses), and choosing the period in such a way that we receive the highest possible EBITDA value.
Net borrowings
Calculation: financial debts – liquid assets and cash equivalents
Financial debts include, among other things:
a. accepted financial debt items: bank loans, leasing, accrued interests, prepayment and loan cancellation charges, corporate income tax, dividends payable, suppliers for projects;
b. generally accepted debt-like items: the costs of the proposed company sale transaction, loans received from affiliated parties, costs related to the change of owner, overdue trade payables;
c. debt-like items may also include: employee bonuses, deferred investments, liabilities arising from disputes, derivative transactions.
The inclusion of the items listed in points b and c is not always clear, and is subject to the agreement of the parties. Obviously, the buyer will want to make this list as short as possible.
Items to be taken into consideration for the calculation of liquid assets and cash equivalents (non-exhaustive list):
a. accepted items: balances freely available in bank accounts, cash on hand, liquid securities (e.g. government bonds) and interest accrued on these, loans granted (e.g. to employees, affiliated parties), deposits given related to real property leases;
b. cash equivalents may include, for example, investment brought forward;
BUT they should not include liquid assets that are not freely available (“trapped cash”), which the buyer cannot use without restrictions for various reasons (e.g. prompt collection order given to banks as collateral, dividend payment limit, other tax-related restrictions).
The Seller’s aim: keeping the financial debt as low as possible, and the balance of liquid assets and cash equivalents as high as possible.
Working capital position
Calculation: working capital balance at the time of closing (when the possession of the company is transferred) – reference working capital.
Experience has shown that one of the most controversial areas of the negotiations is the determination of the working capital position. The purpose of determining the value of the reference working capital is to know the average value of the capital required for the company’s ongoing business activities.
Working capital at the time of closing includes, among other things:
a. accepted working capital items (to be taken into account as positive for assets and as negative for liabilities): inventories, trade receivables, trade payables (but excluding suppliers for project or overdue overdue trade payables), accrued incomes (except interests), other receivables/other short-term liabilities (e.g. VAT, public charges, but the corporate income tax is part of the net borrowings (!)), deferred expenses (except interests), provisions;
b. generally accepted working capital items: among other things, deferred revenues (e.g. the accounting of grants).
The calculation of the reference working capital:
a. It is very important that, in order to ensure comparability, the elements of the reference working capital should be identical in their content to the elements of the working capital at the time of closing.
b. The reference period for the working capital is the most frequent subject of debates in the course of transaction negotiations. Most often (if the company is able to extract monthly data), the average working capital for 12 months is calculated – this method represents about 2/3 of the transactions, while in the remaining 1/3 of the cases, the parties calculate on the basis of some other reference period. In general, the EBITDA period is taken into consideration also when selecting the reference working capital period.
The Seller’s aim: to show as high a working capital as possible and the lowest possible reference working capital value (choosing the period in the most advantageous way).
Overall we can conclude that sellers need comprehensive and thorough knowledge to maximise the value of their company. An in-depth knowledge of financial indicators and concepts is essential in the course of the negotiations, which is why it is worth asking for the involvement of experienced consultants with appropriate references when preparing to part with the results of what is often a whole life’s work. It is worth reviewing these issues already at the beginning of the process or – in case we are in the position of the buyer – we can use the results of the financial due diligence to discover the factors that can influence the amount of the purchase price to be paid favourably.