June 13, 2020
The Bottom Line: Money in Your Pocket
Translating headline value to owners’ net proceeds
- There is a difference – sometimes a big one – between the headline purchase price of a deal and the cash an owner puts in his or her pocket.
- Pay close attention to working capital and how it impacts seller proceeds.
- A good advisor helps a seller project each potential adjustment to net proceeds, and campaigns for their client at every turn.
Any owner who has been through a transaction can attest to the difference between the “golf course number” – the maxed-out, perhaps hypothetical, headline purchase price of a business – and the true number that he puts in his pocket. Much like a duffer’s 19th hole score, the headline number rarely tells the full story. After all, you can’t spend a multiple, and you can’t take a mulligan after closing. Savvy owners and their advisors focus on the bottom line: net, after-tax sale proceeds.
“Cash-Free, Debt-Free”: Translating Enterprise Value to Equity Value
The value typically referenced by buyers, sellers, advisors – even the press! – when discussing a transaction is enterprise value, which represents the elements instrumental to the ongoing operation of a business. These include: tangible assets, intangible assets, assets like reputation and institutional knowledge that aren’t on the balance sheet, and even some short-term liabilities created in the ordinary course of operations, such as accounts payable.
Enterprise value differs from equity value, which is the value of the owners’ stake in an enterprise, apart from the claims of others – most notably creditors. Likewise, there may be assets owned by a business, and by extension its owners, that do not contribute to operations – including excess cash. Equity value is what remains when cash and other non-operating assets are added to enterprise value and debt is deducted. In deal negotiation, enterprise values are often expressed on a “cash-free, debt-free” basis, meaning that cash and debt balances are either retained by a seller, satisfied at closing or assumed by the buyer with a corresponding adjustment to sale proceeds.
Most owners and operators are quite familiar with working capital as a measure of their company’s short-term liquidity. In its simplest form, net working capital equals all of a company’s current assets, minus all of its current liabilities – the balance sheet items that are likely to be realized, turned over or satisfied within a year.
Operating working capital, a similar measure that excludes cash, debt and other non-operating items, can also serve as a window into capital efficiency. It may be expressed as a certain number of days-of-sales, describing how quickly a business can convert sales into cash profit. In an M&A context, working capital can be the focus of a lot of attention…and the source of much confusion.
Both the assets and liabilities included in operating working capital (remember, in a “cash-free, debt-free” transaction, cash and debt have been adjusted for separately) are considered a component of enterprise value. Why? For a business to operate and generate cash flow without a hiccup, it must have a certain level of working capital – something to prime the pump. This normal working capital level is implied in the valuation of the enterprise. In other words, when a buyer or investor takes control, the business won’t need an influx of working capital in order to continue generating cash flow through normal operations.
The challenge arises from the effects of timing and the fluctuating nature of working capital accounts. Buyers and sellers often address this by determining a target level, or peg, for net operating working capital to be delivered on the date of close. Although a number of methods exist to arrive at a target, particularly for seasonal or fast-growing businesses, it is often determined based on a twelve-month or other recent average. Once the appropriate components of operating working capital have been identified and a target net level has been determined, an as of balance must be calculated for a specific closing date. To the extent working capital on the closing date exceeds or falls short of the target, the purchase price is adjusted accordingly.
Lines of credit, bank notes and other debt often must be paid off at closing with transaction proceeds. Accounts payable and similar operating liabilities are generally assumed as part of the working capital calculation.
But what about other liabilities of the company that the parties are unable to – or choose not to – satisfy at closing? These may include capital leases, longer-term deferrals, and even pension obligations. Similarly, there may be company-level tax obligations pertaining to the period before closing but not yet due – including income, property, and payroll taxes. These liabilities are assumed by the buyer and they generally reduce proceeds to sellers at closing.
Many businesses have phantom stock plans or other payments that may be prompted by a sale or change in control. Certain obligations relating to third-party contracts may also be triggered by a deal. And sellers may decide to pay retention or transaction-related bonuses to ensure company stability or reward key employees through the sale process. Sometimes these payments are paid by the seller or shared by buyer and seller. Either way, owners should consider their impact when calculating net proceeds.
In addition, a seller may have individual obligations that impact net sale proceeds. Transaction expenses – attorney and investment banker fees and diligence costs – are often due at closing and paid out of closing proceeds. Similarly, an owner may have personal expenses relating to estate planning, entity restructuring or other pre-transaction services that should be considered.
Often the biggest impact on proceeds, depending on the particular transaction structure, is the seller’s tax obligation. Most transactions involving a healthy business create ordinary or capital gains, the tax consequences of which can substantially reduce net proceeds. Sellers should seek the advice of tax and accounting advisors as early as possible in the transaction process to identify any constraints or transaction structures that could result in a more favorable outcome.
Holdbacks and True-Ups
A fixed portion of proceeds is often placed into escrow at closing or otherwise reserved for payment later (separate from seller financing or contingent payments based on future performance), to cover potential indemnification claims or other areas of uncertainty in a transaction. Unless claims arise, these funds are often dispersed at a later date, but sellers should be aware of the impact they have on proceeds at closing.
In a healthy ongoing business, many of these items and adjustments fluctuate or can only be accurately measured in hindsight. Buyers and sellers may need to estimate the balances as of closing for such things as accounts receivable and accrued taxes. To allow for this, most deals include a true-up calculation performed post-closing.
Although refinements are inevitable as closing approaches, most adjustments to the purchase price can be quantified to a large extent early in the transaction process. A good M&A advisor is adept at identifying these and other situation-specific items that will affect proceeds. The best advisors identify trade-offs, work with their clients to determine strategies to maximize net after-tax proceeds and even customize the transaction process to ensure the best bottom line outcome.
For more insights from the series, The Path to Private Company Liquidity: A practical guide to M&A for business owners, click here.