Enterprise value, equity value, and pricing in business sales
For business owners considering selling their companies, the final price a buyer pays – known as the equity value – can differ significantly from the initial enterprise value (EV). Understanding this distinction is crucial to managing expectations and navigating the transaction successfully.
The enterprise value often serves as the headline figure and is typically calculated as a multiple of the company’s normalized “EBITDA” (Earnings Before Interest, Taxes, Depreciation, and Amortization). This multiple reflects the buyer’s assessment of the business’s risk, growth potential, and industry benchmarks. For example, a buyer might propose: “We’ll purchase ABC Limited for £10 million based on a normalized EBITDA of £2 million and a multiple of 5.” However, this EV calculation doesn’t account for a company’s cash, debt, or working capital at the time of sale.
To arrive at the equity value – the actual amount paid – the buyer adjusts the enterprise value for the target’s cash, debt, and working capital. This adjustment process is often referred to as the “EV-to-equity bridge”. Here’s a simplified example:
- Enterprise Value (4x EBITDA): £24M
- Plus Cash: £4M
- Less Debt: (£7M)
- Plus Actual Working Capital: £2M
- Less Target Working Capital: (£3M)
- Adjusted Equity Value: £20M
Any cash in the business increases the equity value unless the seller withdraws it before completion. Conversely, debts remaining in the company reduce the equity value. It’s also common to debate “debt-like” items – liabilities that may not technically be debt but affect the financial position.
Working capital adjustments ensure the business is handed over with a “normal” level of operational liquidity. If working capital is below normal, the equity value decreases; if above, it increases.
For sellers, understanding how these elements impact valuation ensures they’re prepared to negotiate effectively. Collaborating with accountants and advisors is essential to clarifying these adjustments and securing the best outcome.
Forming the bridge
Accurately determining equity value adjustments is vital, yet there is no universal method for achieving this. Typically, two mechanisms are used to bridge the gap between enterprise value and equity value: completion accounts and the locked box approach.
Completion accounts
Completion accounts remain a common mechanism. Here, a balance sheet is prepared after the completion date to calculate the final equity value. This includes adjustments for cash, debt, and working capital at completion, compared against pre-agreed ‘normal’ levels. The buyer and seller typically agree on estimates at completion to enable an initial payment, with a “true-up” occurring once the accounts are finalised.
The sale and purchase agreement (SPA) outlines how the completion accounts will be prepared. It will usually refer to specific accounting policies bespoke to that deal, and thereafter being in line with prior annual accounts and general UK accounting principles. In most cases, buyers will prepare the first draft of the completion accounts (due to their financial stake and control of the company post-sale). Sellers retain the right to review and dispute specific figures. If disputes arise, an independent expert, either agreed by the parties or appointed through the ICAEW, is engaged.
The completion accounts mechanism ensures a fair and accurate adjustment, enabling either the buyer to pay more or the seller to reimburse funds, depending on the true financial state of the business at the moment of completion.
Locked Box
The locked box mechanism on the face of it offers greater simplicity and certainty, making it increasingly popular. Here, the price is based on a historic, often audited balance sheet from the “locked box date” with no value permitted to leave the business after the locked box date i.e. the ‘box’ is ‘locked’. As such, they avoid time being spent post-transaction on completion mechanisms and bring certainty for both parties on the final equity value at completion.
Because of the way they are structured, the economic ownership transfers of the target company effectively transfer on the “locked box date”, even though completion might not happen until weeks or months after.
To protect the buyer from the seller(s) withdrawing assets unfairly before completion, the locked box approach prevents any “leakage” of value (e.g. dividends or inflated salaries) between the locked box date and completion. The SPA also specifies “permitted leakage”, such as normal salaries or agreed dividends. Any unauthorized leakage triggers a pound-for-pound reimbursement from the seller.
To address value growth between the locked box date and completion, a value accrual mechanism may be included. This accounts for profit generated after the locked box date, ensuring the seller is fairly compensated for the business’s ongoing success.
Choosing the right mechanism
Each method has unique benefits, with the choice often depending on transaction specifics and the parties’ preferences. Completion accounts are ostensibly fairer but require post-completion adjustments, while the locked box mechanism offers speed and certainty.
Navigating the complexities of completion mechanics is crucial to ensuring a smooth and fair transaction. Whether you are considering a sale, negotiating terms, or simply exploring your options, our team has the expertise to guide you through every step of the process. We’d be delighted to assist you in achieving the best possible outcome for your business—please don’t hesitate to get in touch.
| Completion accounts | Locked box | |
| When is the final price i.e. the equity value known | Post completion | Pre/at completion |
| Mechanism to adjust price in SPA | Yes – Completion Accounts schedule and clauses re purchase price | No – price stated as a figure. |
| Buyer protection | Deficiencies in the target’s business picked up in completion accounts | Due diligence, locked box warranties and anti-leakage provisions |
| Possible in trade/business sale (as opposed to share sale) | Yes | No |
| Economic risk transfers | At completion | From the locked box date (but subject to value accrual and any price change negotiated as a result of due diligence prior to completion) |
| Fairness/Risk perception | Fairer (in that the price is definitely the state of the target business as at completion) | One or other side may lose out if the performance post locked box is out of the ordinary and not accounted for in a final price change. |
