Net debt: from enterprise value to equity value

Why this bridge exists

When people say a company is worth four times EBITDA, they are valuing the trade as if it stood on its own: no debt, no cash, no history. It is the only way to compare two companies in the same sector with different financing.

What you sell, though, is the shares of a particular company, with its loans, its cash and its obligations. The bridge from enterprise value to equity value turns one figure into the other.

What counts as debt

The definition in the share purchase agreement often catches more than the loans on your balance sheet. The usual approach is to capture financing and debt-like obligations that sit outside normal trading working capital, without counting anything twice.

• Bank loans, including any balance left on a Bounce Back or CBILS loan.
• Overdrafts and revolving facilities, at the amount drawn.
• Hire purchase and finance leases.
• Loans from directors and shareholders, including credit balances on directors' loan accounts.
• HMRC Time to Pay arrangements and overdue PAYE, VAT or corporation tax.
• Corporation tax on profits earned before completion that has not yet been paid.
• Invoice finance used beyond normal trading terms.
• Accrued bonuses, deferred pay and some employee liabilities, if the parties treat them as debt-like.
• Dividends declared but not paid.

What does not count: trade creditors on normal terms. They are part of working capital and dealt with separately.

Which cash is included

How much cash goes into the bridge depends on the definition of cash and the price mechanism. The business may need cash to operate, and some balances may be trapped, such as customer deposits or cash held as security.

The right level depends on your payment cycle, seasonality, payroll and tax dates and the facilities available. It should be supported with monthly figures and a cash forecast, not a rule of thumb.

A high balance on completion day may come from one large receipt and be gone the next month. That is why cash and working capital are looked at together, over a representative period.

The working capital adjustment

This adjustment makes sure the company is handed over with a level of working capital that fits its normal trading and matches the target agreed between the parties.

The parties agree a target, often called the peg, usually based on monthly averages adjusted for seasonality and changes in the business, and compare it with the actual figure at completion. If working capital is below the peg, the buyer deducts the shortfall from the price, because it will have to put that money in. If it is above, the excess is added.

The mechanism also cancels out short-term moves such as chasing debtors hard, delaying supplier payments or running down stock before completion. Agree the definition, the peg and the accounting policies before you sign.

Completion accounts or locked box

UK deals use one of two mechanisms to fix the final price.

Completion accounts. The price is agreed on a cash-free, debt-free basis and adjusted after completion once accounts are drawn up to the completion date. You get paid for the actual cash and working capital on the day, but the final figure is only known weeks or months later and can be disputed.

Locked box. The price is fixed by reference to a recent balance sheet, the locked box date. From that date the economic risk passes to the buyer, and you promise that no value has leaked out to you, through dividends, bonuses or management charges, except for permitted leakage listed in the agreement. There is no adjustment after completion, so you know the price on the day you sign. It works best when your accounts are reliable and recent.

Contingencies and non-trading assets

Contingencies

Employment tribunal claims, an open HMRC enquiry, customer claims, environmental obligations or guarantees given for third parties are not automatically debt. Depending on how likely and how measurable they are, and how the agreement is drafted, they can be treated as debt-like items, covered by a specific indemnity, a retention or escrow, or a cap on liability.

Hiding them damages trust and widens due diligence. Explaining the issue, how likely it is, what it could cost and how it can be resolved works better than an offer built on a wrong assumption.

Non-trading assets

Property not used in the business, shares in other companies, cars used privately, artwork or land. If they are outside the scope of the deal, they can be taken out, sold separately or reflected in the price.

Taking them out can trigger tax, costs and consents. A large cash or investment pile can also affect your Business Asset Disposal Relief, because the company has to be a trading company. Look at this well before you go to market, and do not assume that extracting assets is always the best answer.

A worked example

The enterprise value was £1.1m and the example arrives at an equity value of about £722,000. The arithmetic is simple. What gets negotiated is how the agreement defines each item, the date on which it is measured and how disagreements are settled.

How to prepare and negotiate the adjustments

There is a lot you can do if you have time:

• Repay debt with surplus cash. Value-neutral for you, but it simplifies the deal and improves how the business looks.
• Clear Time to Pay arrangements before you go to market. An open arrangement with HMRC weighs more on a buyer's view of risk than on the numbers.
• Settle open disputes. An employment claim settled for £15,000 is worth more to you than one left open and valued at £25,000, because it removes uncertainty.
• Keep working capital steady. Twelve months of consistent behaviour is a better argument for the peg than any explanation.
• Deal with non-trading assets early. With the tax cost worked out and the transaction done before the buyer starts due diligence.

Frequently asked questions