Looking at selling your business? If you think that agreeing on the business’ value is the hard part, think again. Many owners overlook the question of the purchase price’s net working capital adjustments, let alone how much cash to leave in a business at the point of sale. These areas are not only complex but can often be a major source of tension towards completion of a business sale. So, while it’s best to ensure you have a skilled advisor on hand to help you navigate your way through, this article will help you understand some of the considerations involved before you head to market.
Avoiding surprises
If you’ve read a broker report or looked at some analytics of public listed companies, you will see that that all net working capital is included, and all cash is treated as a surplus asset when determining its equity value. For example, look at these companies listed below:
| $A Million |
Apple Inc.
(AAPL) |
Harvey Norman Holdings
(HVN) |
G8 Education (GEM) |
ASX Small Ords (^SXO) |
| |
Tech Juggernaut |
Retailer (mostly) |
Child care owner operator |
Diverse, and not that “small” |
| Total Enterprise Value (TEV) |
1,359,869.7 |
5,452.8 |
1,690.1 |
n/a |
| Plus Cash & Short Term Investments |
114,459.5 |
150.9 |
56.9 |
n/a |
| Less Debt |
(160,959.5) |
(832.6) |
(371.8) |
n/a |
| Market Capitalisation (EV) |
1,313,369.7 |
4,742.5 |
1,375.2 |
n/a |
| |
|
|
|
|
| Cash % to Revenue |
30.9% |
7.0% |
2.0% |
9.1% |
| Cash % to EBITDA |
103.6% |
28.4% |
38.8% |
67.2% |
| NWC % to Revenue |
5.0% |
44.5% |
16.1% |
13.5% |
| EBITDA / TEV |
12.3x |
10.1x |
11.4x |
12.5x |
(Source S&PCapIQ June 2019 and MSV analysis)
If you were to buy any of the above companies on a cash-free debt free basis, would you be happy paying the Total Enterprise Value (TEV) and not leaving any cash in the business? Would you get a nasty surprise and be forced inject cash on day one to pay its expenses? Is there actually some level of minimum operating cash that is really part of net working capital and TEV? To answer these questions, you need to understand some fundamentals.
What is Total Enterprise Value?
Total Enterprise Value (TEV) is the value of all the businesses operating assets. The operating assets are all the assets needed to generate the earnings or future cash flows of the business. Operating assets typically include:
- Net Working Capital such as debtors, stock, creditors & accruals
- Property, Plant & Equipment
- Intangible assets such as formal trademarks, brands, patents, licenses and goodwill. Goodwill includes customer relationships, workforce, locations, know-how etc.
It’s important to note that cash is not included in the above list.
In private business valuations or sales, TEV is usually estimated first. This is because there is no market share price for valuing the equity directly. TEV is typically estimated as a multiple of earnings.
In very small cash trading type businesses, the TEV might be broken down to its components and negotiated separately. This could include the stock at value, plus the property, plant and equipment and a smaller multiple of revenue or earnings for goodwill.
Irrespective of how it is determined, the TEV should have some relationship to the earnings and cash flow the business generates. After all, the point of purchasing a business is to obtain its future cash flow and make a return on investment that is better than an alternative investment with similar risks.
What is the Equity Value?
The Equity Value (EV) is the value of the shares or equity holders’ interests in the company. The difference between TEV and EV is due to surplus assets like cash and debt as shown in the table above.
The Equity Value for a private business is calculated by adding surplus assets and deducting debt. A surplus asset is any asset you don’t need to generate future earnings. Cash, aside from interest, does not generate future earnings so is regarded as a surplus asset.
Debt is deducted as it must be paid first from the business assets and cash flow before equity holders. In its simplest form, TEV is the price you can sell your house for, while EV is what you get after you pay back the bank. The more debt you have, the less EV you have.
In the case of public companies, the EV is a traded price for the shares. So, in the examples in the earlier table, we work backwards from market capitalisation to derive the TEV.
What about price adjustments?
When a business is being sold as a going concern, typically the vendor and purchaser initially the negotiations are based upon TEV, on a cash-free debt-free basis. There is usually a multiple earnings calculation that frames the valuation negotiation, with the buyer considering how they will fund the transaction, and what the future return on investment will be.
Leaving aside tax considerations, the vendor will usually want to exit the business with all the cash, and the buyer will want the vendor to pay out the debt or debt-like items such as excessive leave provisions or dividends payable. The extent of these amounts at sale, will ensure the purchase price is adjusted up for any cash and down for any debt on a $1 for $1 basis. So far, this should be entirely consistent with the reconciliation between TEV and TV.
The problem of net working capital
What of the net working capital? Remember, NWC does not form an adjustment to value. This is because TEV assumes all assets are needed to operate the business and generate the earnings on which the valuation was agreed. All the assets include the NWC.
But as any business owner will know the NWC tends to move around. This movement can be due to:
- Timing of debtor receipts: for example, if a major customer pays just before completion, then this will appear as cash and be taken out by the vendor. However, the buyer will then start with a lower than normal NWC.
- Delayed creditor payments: a vendor could delay paying creditors to retain cash paid out to them at exit, but the buyer will be left with a lower than normal NWC.
- A seasonal build up in inventory: retailers typically build up inventory before Christmas. If the vendor delays this, a buyer in November will be in for a nasty shock come December.
- Impact on accruals of quarterly or irregular payments: such as taxes and subscriptions.
- Style and operating cycle of the business: a commercial bakery, for example, that mostly sells on a cash on delivery basis, but purchased raw materials on 60-day terms, making its normal NWC balance negative.
- Impact of deferred revenue, work in progress and accounting adjustments: subscription businesses or builders typically bill the initial instalment in advance and costs as work in progress.
- Revenue and expenses are only brought to account per stages of completion. The offset to deferred revenue will either be sitting in cash or debtors. Deferred revenue can therefore be treated as part of the NWC or as a debt-like item or a bit of both.
Setting the target NWC, therefore, becomes an essential part of the acquisition and due diligence process. First it must be agreed what is, and is not, included in the definition of the NWC. While there’s several schools of thought, it should be those balance sheet items that are likely to generate or consume cash in the short-term at their realisable values. Under this premise, you can usually exclude non-cash accounting items like deferred tax assets or liabilities and employee provisions.
There are all sorts of target NWC setting methods used including: 12-month financial year historical averages, rolling 3-12-month averages, average trading terms days or count backs, the NWC forecasts per a three-way forecast model. As for any valuation, the emphasis should always be on the future.
Setting a reliable target NWC, along with maintenance of normal trading terms up until the sale’s completion helps to ensure the buyer gets the right level of NWC. However, the process of agreeing the target NWC and the adjustments can be almost as much as a negotiation as the TEV itself. This is where professional advice can really assist.
How much minimum cash?
All cash is regarded as a surplus asset in the above public company table. However, as any business owner knows, you either need a cash buffer or an overdraft to manage the ebbs and flows of cash across a month. So, the buyer should either be prepared to contribute this cash float post-sale or negotiate a minimum level of cash to be retained in the business at completion.
How much operating target cash that should be left in a business at sale must be determined much like the target NWC, through historical and forecast analysis of cash balances which is relative to sales or operating expenses. There is no rule of thumb answer as we can observe (see chart) that actual cash balances retained by companies in practice is diverse.
Source: S&PCapIQ June 2019 and MSV analysis
To understand the trading terms and intra-month cash cycles the sources and applications of funds need to be analysed. If all customers tend to pay in the second week of the month, but wages and rent are due in the first week, then clearly there will be a shortfall in the first week of ownership. This effect is typically exacerbated in service businesses (like GEM) as wages are paid regularly and employees are not funded by creditors. This is different from say a trading business like HVN, where creditors typically fund most stock and a portion of debtors depending upon relative terms.
Consider also a business that bills in advance and has significant deferred income – a subscription style of business or a builder’s initial instalment. Deferred income will sit among the NWC and could be treated as forming part of NWC like any other creditor. The deferred income liability balance will therefore reduce the overall NWC balance. Alternatively, the deferred income can be treated as liability as a debt-like item, particularly if the asset side tends to sit more in cash if the customers have actually paid in advance.
If it’s accepted that TEV includes all assets necessary to run the business and generate the earnings, then arguably a minimum level of operating cash is also required. It’s then a question of is this included within the TEV or should the buyer pay for all cash-on-hand as a surplus asset?
Who pays?
If the TEV has been derived on a discounted cashflow basis, then all cash is generally surplus, and the buyer pays. This is because any near-term shortfalls or adverse NWC movements should already be in the net present TEV value.
But if TEV has been derived as a multiple of earnings, then it becomes a little less precise. There are examples of many deals where the TEV purchase price has been derived from a multiple of earnings and has been negotiated as inclusive of a level of target NWC and target cash, which in this case, the seller pays.
The reason for setting a target cash level is simple enough from the buyers’ point of view:
- It helps to remove some of the uncertainty in setting the Target NWC level and risk of ’gaming’ NWC prior to completion; and
- It helps to avoid the risk for the buyer of having to put in cash on day 1 to keep the business going.
- In service businesses, it is reasonable to argue that a minimum level of cash is needed to fund short-term operating expenses like wages, which the seller pays.
When deferred income is significant, it is often better to treat the deferred income separately as a debt-like item and deduct from the TEV purchase value, and which the buyer will then likely have to contribute in. The other option is to retain cash to offset the amount, so the seller pays.
How we can help
Moore Stephens can assist in the analysis of target NWC and minimum target cash levels as part of any business sale discussions. We can also assist in preparing presentations to banks to arrange or maintain operating facilities post completion.
For more information or to discuss the sale or purchase of a business, please contact our Corporate Finance team.