Acquisition Balance Sheet – Where Deal Structuring Takes Place (Part 1 of 2)

Acquisition Balance Sheet – Where Deal Structuring Takes Place (Part 1 of 2)

How a business transaction is priced, differs from how it is structured.

Business transactions are priced from the income statement.

Business transactions are structured from the balance sheet

Let’s begin with pricing. The common pricing formula is:

EV = E x M

Earnings (E) is often represented by earnings before interest, taxes, depreciation and amortization (EBITDA), derived from the income statement (adjusted for discretionary and non-recurring items). EBITDA is the operating cash flows which must satisfy the buyer’s four claimholders to cash flows: 1) investors (ROI), 2) lenders (P&I), 3) company (W/C and CapEx), and 4) Uncle Sam (taxes).

To what degree a buyer is willing to pay to receive the seller’s future operating cash flows is represented by a market multiple (M) – which again, largely depends upon satisfying the buyer’s claimholders to cash flows. The Enterprise Value (EV) the buyer receives is essentially the operating assets of the business. What specific operating assets being purchased depends upon how the transaction is structured – the subject matter of this article.

Darrell V. Arne
Investment Banking Representative

Economic Balance Sheet

When a buyer pays a certain multiple for the right to receive future operating (3) classes of cash flows (e.g. EBITDA), the resulting Enterprise Value (EV) is comprised of three operating assets:

  • Working Capital
  • Fixed Assets
  • Intangible Assets

Let’s examine each of these asset classes for structuring issues.

Structuring Working Capital

The most challenging aspect in structuring a transaction surrounds Working Capital. One reason – it’s always changing. From a business transaction standpoint, Working Capital only considers current operating assets less current operating liabilities. In a business transaction, it’s those: a) assets and liabilities needed to produce operating cash flows, and b) those assets with that are converted to cash within one year, and those operating liabilities extinguished within one year.

Structuring Issues

• Define what working capital accounts are included. For example, cash, accounts receivable, inventory, prepaid expenses, accounts payable.

  • From a current liability standpoint, the position often taken is that there should be a corresponding current asset purchased. For example: accounts payable with inventory, deferred revenue with accounts receivable, customer deposits and cash.

• Define how much working capital is needed (i.e. Benchmark or Target Working Capital)

  • Methods to determine the amount of needed working capital include: a) monthly averages of working capital accounts, b) industry ratios, c) projected financial statements, and d) the Bardahl Method (see article) .

• Other Working Capital structuring issues that may arise:

  • The stated level of inventory has historically been understated, or has been reinstated in one period. How will this effect operating cash flows and the pricing of the business?
  • The composition of the defined working capital accounts changes from what was originally defined, to what exists at closing; particularly if the buyer’s source of debt capital is based upon differing advance rates against current operating assets (e.g. accounts receivable vs. inventory).
  • The seller has accounts receivable that are beyond what a buyer’s lender will finance. Should those receivables be excluded from working capital? If not purchased, structure a payment to the seller when the buyer collects?
  • The seller has excess inventory that is beyond what the business requires and buyer is willing to purchase. Should this inventory be excluded from working capital? If not purchased, structure a payment to the seller when the buyer sells (similar to consigned inventory)?
  • Buyer assumes the seller’s accrued salaries and accrued vacation to accommodate the transitioning process. Define as part of what constitutes working capital? Treat as a non-operating liabilities and an additional payment to the seller (and no adjustment of the transaction price)?
  • Buyer assumes the seller’s unearned revenue and customer deposits. Require seller to leave equal amount of cash behind? Treat as non-operating liabilities and additional payments to the seller?

To be continued later this week.

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