THE PURCHASE PRICE EQUATION
Below provides an overview of the main components to the purchase price and how they fit together.
Enterprise value represents the total value of the Company (both debt and equity). It is calculated by determining the Company's pro-forma, normalized and adjusted EBITDA, then applying a multiple.
Adjusted EBITDA represents what we expect the Company to make in a typical year based on its historical performance and considering its forecast opportunities.
The multiple represents 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. The multiple is often calculated in reference to other similar companies, or "comparables", and / or similar precedent transactions, to the extent they exist.
WORKING CAPITAL ADJUSTMENT
When a Company is purchased, it is generally for its future earning potential. A buyer is largely paying on the Company's Adjusted EBITDA. However, a company needs capital to fund its day-to-day operations in order to be able generate those earnings. Illustratively, if the Company is in manufacturing, it would need to fund payroll and purchase orders, etc., to fill customer orders before it would be collecting cash on its sales. A company requires working capital to fund the time delay between incurring its operating expenses and receiving cash for revenue. Think of net working capital as the amount of capital the Company needs to fund day-to-day operations for timing differences in cash inflows (accounts receivable) and outflows (inventory and accounts payable).
As a buyer, you do not want to purchase a company and subsequently discover you now need to put more capital into the business to fund the operations which generate the earnings you paid for as a part of the purchase price. Therefore, it is critical to determine the amount of working capital the business needs as a part of due diligence. On close of a transaction, an adjustment is made to the purchase price such that the right amount of capital is left in the business.
Similar to working capital, as a buyer you want to know that when you purchase a company the machinery, vehicles and major capital items are in good working order such that you do not need a major capital investment post-close just to keep status-quo. It is not uncommon once management decides to sell that large capital expenditures are put off. If a buyer is paying for earnings based on a fleet of 50 trucks, the buyer should also understand how old these trucks are, the amount of maintenance required, and the general condition of the assets prior to paying for the earnings to be generated from these assets. If it is found that there will be major maintenance required post-close to maintain status-quo, these costs can be deducted from the purchase price.
Net debt is "net" because it is the total of the Company's debt less its cash. Most transactions are assumed to be on a cash-free and debt-free basis so that the buyer does not need to assume the past capital structure of the business. Different owners have different credit worthiness (and accordingly, a different cost of capital) and preferences on capital structure. Removing past debt allows the new owners to re-finance as they see fit. The net debt adjustment is what takes us from the Company's total value / enterprise value to its equity value / purchase price, by removing net debt.