Due Diligence and the Purchase Price
One of the first questions that comes to mind for most of our clients is – what is the right price for this deal? In practice, how we evaluate total price is by breaking it down into various pieces.
When we think about what we are buying when we purchase a business, it is generally that we see value in the future earnings that the company or its assets will generate. This leads to two pieces: how much will it make in a year (“Adjusted EBITDA”); and, for how many years (“Multiple”)?
This gives us a value for the total company or “Enterprise Value”. As the purchase price is for the equity of the company, the “Net Debt” of the business is deducted from the Enterprise Value to determine the value of equity.
Finally, not all earnings are equal, some take more capital. Therefore, there are structuring and capital requirement considerations that adjust the equity value to get to the actual price to be paid. Top-ups can be done for day to day capital requirements (“Working Capital Adjustment”) and longer-term capital expenditures ("Capital Expenditures") in order to ensure the business is left with the capital it needs to generate the earnings that are being bought.
Below is a summary of the purchase price equation:
Before we dive into each element of the purchase price, let’s pause for an analogy which may bring the purchase price equation to life in a more concrete fashion.
Think about buying a car in a private sale. You believe the used car will cover your transportation needs of about $5,000 a year (the Adjusted EBITDA) for 4 years (the Multiple). The car is then worth $20,000 (the Enterprise Value).
The previous owner financed the car and has $10,000 of principal left owed to the bank (the Net Debt). Your bank is willing to replace the previous owner’s loan and finance the $10,000. This would result in you paying the remaining $10,000 (the Equity Value).
When buying a new car you expect it to come with a full tank of gas (the Working Capital) and with parts that are in proper working conditions (the Capital Expenditures). When you go to pick up the car, you notice the tank is only half-full and that there is a dent in the side-panel. You negotiate with the seller to pay $50 to top up the tank and $1,000 less to fix the side-panel.
The ending purchase price then becomes $8,950 ($20,000 - $10,000 -$50 - $1,000).
Now we will jump into each piece of the purchase price equation and how due diligence comes in.
1) Adjusted EBITDA
Adjusted earnings before interest, tax, depreciation, and amortization or Adjusted EBITDA is a metric used to represent the cash flows that a business is expected to generate in a typical year.
EBITDA is typically calculated using the historical financial statements or a forecast prepared by the management of the target. One method of calculating Adjusted EBITDA is to take operating income before taxes, add back interest, depreciation, and amortization, and then adjust for non-cash, non-recurring, and accounting related items.
As the above adjustments are not black and white, due diligence professionals are hired to perform a quality of earnings (“QOE”) report that looks at the revenue and expense items in detail to ensure that Adjusted EBITDA is representative of the company's sustainable earnings. To give you an idea of what we look at in a QOE report, we have listed a few examples below:
2) The Multiple
The Multiple is a measurement of the perceived quality of the company and is derived from a combination of factors such as industry, size of the company, stability, and recurrence of cash flows, as well as market conditions.
So how do you determine if the Multiple you are offering or receiving is reasonable? One approach is to look at comparable public companies or comparable precedent transactions and calculate the implied multiple from those data points. From there, the qualitative and quantitative factors of the target company are compared to the public companies and precedent transactions to determine which are the most comparable. A Multiple can then be selected based on the most comparable companies and then further adjustments can be made in consideration of any differences between the target and comparable companies.
The below picture shows a simple example of how comparable public company data can be used to assess the Multiple offered or received.
3) Working Capital Adjustment
As discussed earlier, the Working Capital Adjustment is the equivalent of making sure have a full tank of gas.
Even though working capital is easy to calculate (current assets - current liabilities), the Working Capital Adjustment is one of the most contentious areas in determining the purchase price. Below are some reasons as to why:
Have all the appropriate items been included in determining the required working capital? Are there any grey area items that need to be discussed or negotiated?
Are there any accounts that have not been recorded in the financials in the past, and need to be accounted for in determining required working capital?
If the historical working capital is seasonal and changes quarter to quarter, what would be considered the “normal”?
See the picture below for an example of key takeaways from looking at a target’s working capital.
4) Capital Expenditures
As discussed earlier, the Capital Expenditure adjustment is used to adjust the purchase price for any capital expenditures required to get the business to an acceptable working condition.
Below are some capital expenditure related items to consider when purchasing a business:
One item to consider is deferred capital expenditures. For example, if you purchase a house with a leaking roof, would you not consider the replacement cost of the roof in the purchase price?
Another item to consider is how the capital expenditures related to expanding the business are considered. If the adjusted EBITDA used to determine the purchase price considers future growth, then capital expenditures required to achieve that growth should be considered as well.
See the picture below for an example of key takeaways from looking at a target’s historical capital expenditures.
5) Net Debt
As stated above, a purchaser is only purchasing the equity of the company, therefore the debt needs to be deducted from the Enterprise Value. Deducting debt may seem like a simple task, but have you considered:
What is defined as debt? Have all these items been disclosed?
Are there any debt-like items that need to be discussed?
Are all claims on assets disclosed?
Are there any unrecorded significant commitments or contingent liabilities?
See the picture below for an example of key takeaways from looking at a target’s historical net debt.
We hope that this post has provided insight into how due diligence elevates the transactions process. Connect with us to chat about due diligence. It is never too early to plan. Reach us at firstname.lastname@example.org to continue the conversation or schedule your complimentary meeting.