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M&A Multiples: Business Value v. Balance Sheet Value

By: Ron Stacey
Founder & Managing Director


Valuation principles generally hold that the value of an economic asset, a business, is a function of return
on invested capital and growth, i.e., the primary drivers of free cash flow. Discounting the free cash flow
by the rate most applicable to the risk, results in the value of the business. M&A price negotiations
typically revolve around these principles as deals from the sell side perspective are negotiated as a
function of EBITDA multiples. The ensuing value is the M&A Enterprise Value. But, how does this cash
flow value relate to the asset/liability values on the balance sheet? Lets find out.
Operating and Intangible Assets

The operating assets on the balance sheet represent the ordinary and necessary assets to produce the cash
flows. Generally, these assets include accounts receivable, inventory, prepaid expenses, machinery and
equipment, real estate (assuming highest and best use). Cash and long term or interest bearing debt, if
any, are excluded hence the term a cash free/debt free balance sheet.

Cash is not an income producing asset save for situations where nominal cash balances are needed to
conduct the business, such as a chain of retail stores. However, if cash balances are accumulated at the
expense of accounts payable, then the appropriate amount of cash or the amount of assumed payables
must be adjusted, usually through a negotiation of a working capital target.

Debt has nothing to do with the value of the business no more than a mortgage has to do with the value of
your house. In the end, debt will either be paid off by the seller from the proceeds of the sale, or assumed
by the buyer and deducted from the sale price. Short term debt, accounts payable and in some cases
working capital lines of credit that clean up annually, as well as normal accruals are generally assumed by
the buyer as part of the working capital calculation. If a working capital line of credit is a permanent
liability, an asset based revolving loan for example, then its included in long term interest bearing debt.

The buyer is purchasing the income stream of the business plus the working capital, the fixed assets that
are necessary to operate the business and the intangible assets including goodwill which is the excess of
the purchase price over the value of the tangible and identifiable intangible assets. Identifiable intangible
assets include customer relationships, assembled workforce, the value of patents and trademarks, and
trade secrets. Certain intangible assets with identifiable useful lives can be amortized for tax purposes
over those lives under Section 197 of the Internal Revenue Code; unidentifiable intangible assets or
goodwill must be amortized over 15 years.
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Non-Operating Assets

Non-operating fixed assets on the balance sheet must be identified and removed from the balance sheet
(theoretically for an asset sale), or become an addition to the purchase price. Examples include assets held
for investment or expansion, and those related to idiosyncrasies of the seller like airplanes, yachts, golf
memberships, condominiums in the Bahamas, or second homes in Palm Beach. To the extent these items
remain, the buyer must buy them separate and apart from the business.
Case Study

In the following example, a $100 million revenue manufacturing company with $15 million in EBITDA
is being sold for a modest 5 times EBITDA or $75 million. The parties to the transaction must negotiate
the appropriate working capital, fair value of the fixed assets and net assets typically tied to the most
recent balance sheet, to be delivered at the closing subject to post closing adjustment or true up, since
balance sheets change on a daily basis. The table below illustrates three case scenarios for this transaction.
The values for the current assets and liabilities are a function of turnover, lower values indicate high
turnover, higher values lower turnover:

000's $'s Case 1 Case 2 Case 3
Revenue 100,000 $ 100,000 $ 100,000 $
Cash 2,500 2,500 17,500
Accounts Receivable 7,500 12,500 12,500
Inventory 10,000 17,500 17,500
Accounts Payable 7,500 7,500 25,000
Working Capital ex cash 10,000 $ 22,500 $ 5,000 $
Fixed Assets Fair Value 30,000 30,000 30,000
Total Asssets 40,000 $ 52,500 $ 35,000 $
Purchase Price 75,000 75,000 75,000
Goodwill and Intanagibles 35,000 $ 22,500 $ 40,000 $


Case 1 illustrates a well run business with good turnovers in receivables, inventories and accounts
payable. Working capital excluding the cash computes to $10 million. By minimizing the working capital
investment, this company produces a higher return on invested capital. The parties agree that the fair
value of the fixed assets is $30 million. The purchase price for the assets is thus $40 million and the value
of the goodwill and intangibles is $35 million.

Case 2 represents a more typical scenario with lower, but closer to normal, real world turnovers. The
accounts receivable are not collecting as well, the inventory turns slower than in Case 1, but the accounts
payable is being kept current and happy vendors are good for a business. If the balance sheet producing
these figures is the one around which the negotiations took place, the parties might agree on working
capital target of $22.5 million; same scenario for the fixed assets. The assets now total $52.5 million; the
value of the goodwill and intangibles is reduced to $22.5 million.

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The Case 3 scenario is the problem child for this deal. In Case 3, the accounts receivable and inventories
are turning normally (however, these can be gamed too) but accounts payable has been stretched to
the limits while the company has accumulated excess cash. And yes, this does happen in real life. To get a
workable deal under these circumstances, enough cash must be in the company at closing to bring the
accounts payable current, or the accounts payable must be brought current prior to closing such that the
working capital deliverable is $22.5 million and not $5 million. Alternatively, the excess accounts
payable can be viewed as long term debt and the purchase price reduced accordingly. In other words,
$17.5 million is needed to fix the problem. One caveat, if the industry is such that the vendors actually
extend 90 day terms then so be it. Nonetheless such terms are not trade financing but long term debt
subject to purchase price reduction. Note also, that a $5 million working capital position, if accepted,
results in $40 million of goodwill and intangibles for all the wrong reasons.
Timing

As illustrated in the above example, three time points are germane to the negotiation. The first is the
balance sheet date around which the Letter of Intent (LOI) is negotiated. The second one is the date on
which the transaction is settled, and the third is the post closing or true up date, usually 30 to 45 days
later at which time the balance sheet delivered at closing is adjusted to the negotiated balance sheet as
reflected in the LOI. Adjustments to purchase price either up or down are made at the true up date.
Definitive agreements provide dispute resolution procedures in the event a disagreement occurs over the
calculation of the true up.
Balance Sheet Deliverables

The balance sheet changes on a daily basis as business is transacted, accounts receivable are billed and
collected, inventories change and cash balances fluctuate. The balance sheet is also affected by profits or
losses over any given period. This dynamic characteristic of the balance sheet means that on closing or
settlement, the balance sheet will likely be different than the one negotiated for the LOI. Since the buyer
receives working capital, fixed assets and the intangibles, the parties to the transaction must set targets for
these items to be delivered at closing.

The working capital target is an agreed upon value that may represent the LOI balance sheet value, or can
be set as an average of the working capital over the last twelve months or alternatively set as a percentage
of sales. If cash is included in the deal, the parties must agree on the amount of cash to be delivered at
closing.

A net assets or net worth test is typically included to account for changes in fixed assets or long term debt
to be assumed by the buyer. The formula is working capital plus fixed tangible assets less debt. All things
being equal, and absent any changes in fixed assets or long term debt, any profits or losses incurred
during the time interval between the LOI and the closing, will be reflected in the working capital or a
change in cash. For example, if a company earns money the profits manifest either in an increase in
working capital or an increase in cash. The converse is true for losses. Until the deal closes and ownership
transfers, profits and losses accrue to the seller. The following is an example of a true up calculation.

Case2$'s000's LOI Closing TrueUp
Cash 500 $ 500 $ - $
WorkingCapital 22,500 24,000 1,500
NetWorth 20,000 21,000 1,000
IncresetoSeller 2,500 $


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The benefit to the seller is $2.5 million increase in purchase price suggesting a $2.5 million profit over the
period split between a working capital asset increase and a debt reduction.
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Normalization

Unlike the income statement, balance sheets rarely need normalizing. Once the working capital target is
set and an agreement reached on the value of the fixed assets, nothing on the balance sheet should require
normalizing with some exceptions. Any change to the carrying value in the working capital components
that impact the cash flows affects the deal pricing. An example is a write down in accounts receivable or
inventory that has not been through the income statement, or the discovery of additional accounts payable
not yet expensed to the income statement. A corollary to the working capital caution, if fixed assets
require major capital expenditures post closing, this expense must be incorporated into future cash flows
and pricing adjusted accordingly. Any non-operating assets need to be priced accordingly or removed
from the balance sheet; an alternative treatment in an asset sale is to create a proforma opening balance
sheet for the new entity and simply ignore non-operating assets that are not part of the sale.
Summary and Conclusion

M&A Enterprise Value is determined as function of discount rates and free cash flows and expressed in
terms of multiples of EBITDA by a sell side investment banker. While the business is valued and sold in
this fashion, the buyer gets the cash free, debt free balance sheet negotiated at the time of the LOI, and
delivered at closing subject to a true up, including the ordinary and necessary working capital, fixed assets
and intangible assets that produce the cash flows. In that the balance sheet is constantly changing, the
parties to a transaction must negotiate delivery targets for working capital, agree on a fair value for the
fixed assets, and set a target for net assets or net worth at closing. Its highly important, particularly for
the buyer, that the working capital target be determined correctly. Final true up of the delivered balance
sheets results in an adjustment, either up or down, to the selling price.

In conclusion, we trust that this article proves to be a useful tool toward a better understanding of the
value of a business and the value of its balance sheet assets.

Ron Stacey is the Founder and Managing Director at Legacy Advisors, a Dallas based boutique
investment bank. Please contact him at rstacey@legacyadvisors.org or call 214 705 1112 with comments
or to request copies of excel spreadsheets used in this article. We look forward to hearing from you. For
additional articles on M&A see www.ronstacey.com