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• ⚽️ Deferred Capex at Manchester United

• ⚙️ Working Capital in M&A

• 🛁 A Chart Made in the Bath

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THE DEEP DIVE

Valuation Part 2: From Enterprise Value to Equity Value

This is week 7 in an 8 week season covering the world of M&A from the seat of the CFO

It’s always the same.

We’re tired. They’re tired.

The last two to three weeks have been 16-20 hour days for the deal team.

Everyone sprinting to get over the line on both sides.

Time kills deals.

Momentum oils the deal wheels.

The deal is mostly agreed. Headline enterprise value is final, after plenty of negotiation.

There are only two or three points of detail left to agree.

Most of these are in the indemnities, warranties and representations in the documents. I’ll leave that to the lawyers.

There is just one 'commercial' point left.

The other side picks up the phone “hey, conscious we need to just iron out the detail of the working capital peg.”

“Thanks for the reminder. we’ve been so busy on the docs, that we hadn’t given it much thought. I’ll come back to you tonight”

Oh … we’ve thought about it alright! We’ve poured through every line of working capital in great detail.

Lining up our negotiating position. Sorting each point of negotiation into order of ‘credibility’. Being ready for one last big trade with the other side.

From my experience, this negotiation is worth 1-3% of enterprise value. A pure $:$ win:lose negotiation between the two sides.

I’ll be honest with you: I love this bit.

I deliberately leave this negotiation as late as possible in the deal. In the hope that it will mean that we have out-prepared the other side. Until this point, I've played off that it’s a ‘detail of documentation that can be handled later’.

Rather than a crucial value point.

Why?

Two words.

Deal heat.

There is a point in a deal, where the dynamic of the transaction shifts. Often, once the price gets agreed, with no / limited conditionality.

The two sides are no longer feeling each other out. The posturing is over. Both sides working together to get the deal done.

‘Execution mode’ is the language used.

The deeper you get into the process, the more cost committed by both sides. More emotional investment. Some of the deal guys have even mentally spent their transaction bonuses.

Everyone wants this to happen.

When you are in the deal heat zone, points that could be negotiated over for weeks, get agreed in minutes.

This can lead to the deal principals letting the guard down in the sprint for the line.

That’s deal heat.

I’ve also heard it charmingly described as the ‘deal b*ner.’

It doesn’t always work, of course.

Sometimes the other side is expecting it, or even doing the same thing themselves.

Especially if you are dealing with an experienced deal maker on the other side (particularly PE).

But in a trade (non-PE) deal, in my experience:

• 20% of the time you meet an equally prepared other side.

• 40% of the time you catch the other side off guard. But they understand what's at stake so it becomes a negotiation. Oftentimes a fractious one. But by putting the first aggressive anchor in the negotiation, you are well placed to win.

• The final 40% of the time, your proposal pretty much gets waved through. Whether it's deal heat, they don't understand what's at stake, or the they are busy on something else.

Either way, when you are talking about 1-3% of enterprise value, that could be a quarter turn of EBITDA.

A big win to play for.

In week 2 of this series, we covered valuation. Specifically, we covered ‘enterprise value.’ We followed this in week 5, with a piece on the quality of earnings that underpin that enterprise value.

The principle of enterprise value is that it values a business on a cash free, debt free basis. And based on a normalized level of working capital.

This basis provides a consistent set of assumptions. Which allows a direct comparison between offers.

This is the main focus for the negotiation and valuation discussion.

But enterprise value is not what is actually paid for the shares. You pay equity value.

Remember this chart from week 2?

Today we are going to walk from enterprise value to equity value.

This is the exercise of truing cash, debt and working capital assumptions up to an actual number.

Sounds simple, but often this is the most technical part or an M&A deal. Working capital in particular.

Let's nerd out, and take each in turn:

Cash

We’ll start with an easy one.

In our enterprise value we assumed that no cash would transfer with the business.

But that may not be the case.

There are practical reasons why it may make sense for cash to move with the target. This could be a function of tax planning. Or just a practical point to help the buyer manage day 1.

Buyer and seller would work together to agree whatever makes sense.

The level of cash that transfers with the business would get agreed between buyer and seller. This purchase price would then get adjusted $:$.

I.e. the amount of cash that the buyer is buying would get added to the purchase price, as they are now buying that cash.

Assuming it’s not restricted in any way, and is truly liquid to a purchaser.

This is rarely contentious, and is a technical position based on closing.

Debt

Think of this like the cash point but in reverse.

Enterprise value assumes any debts in the target would get settled by the seller out of the proceeds upon closing.

But the seller and purchaser could agree that some debts transfer with the business.

For example, if the target has cheap fixed debt they raised during the glory days of ZIRP, the buyer may want to keep it.

It also often makes sense to keep operational debt in the target. Finance leases, receivables financing, etc.

There is a bunch of stuff to work through here. For example, the lender may have included a change of control clauses in the debt documents. This would prevent debts from transferring.

But in reverse to the principle of cash. The value of debt that is transferred from seller to purchaser gets deducted $:$ from the enterprise value.

If you think about this alongside the point on cash. We have deducted the net debt position from enterprise value to reach equity value.

This is like public company analysis where we start with market cap (equity value) and add back net debt to reach enterprise value.

Debt-Like Items.

Straight forward so far? Time to spice it up.

'Debt-like items' are things that are not technically debt, but they look and smell like debt.

They wouldn’t meet the GAAP definition of debt, and maybe don't even have an obvious 'lender'.

Sometimes these are obvious and hard to dispute. Other times, they are subjective, and become core to negotiations.

If it’s likely to lead to a non-recurring cash outflow in the target in the future, it might be a debt like item.

Some examples of debt like items:

• Financial instruments e.g., fx positions, and interest rate swaps

• Finance lease obligations

• Related party balances or current accounts with Shareholders

• Dividend payables

• Severance payables

• Deal bonuses payable

• Deal fees payable by target to the seller’s account.

• Overdue payables (i.e. if your supplier terms

• Deferred capex, capex backlog or maintenance underspending

• Open payables from EBITDA adjustments

• Pending claims

That list is broadly sorted from most ‘factual’ to most ‘subjective'.

Let’s pick one contentious line as example. Deferred capex.

If there is an asset that is being valued as part of the enterprise value, but has a backlog of investment / maintenance capex. A right minded buyer will say to a seller, that they expect to get compensated for taking on that 'liability'.

Let's take a real world example.

M&A in Soccer

The rumored takeover of English soccer team Manchester United by the Qatari Investment Fund.

This is one of the most protracted M&A negotiations of recent times.

The price is rumored to be anywhere between $8bn and $13bn. It will be the biggest sports team deal in history if it happens, by a landslide.

Negotiations have been ongoing for nearly a year. I’m not a fly on the wall, but I suspect one of the items of dispute will have been the treatment of deferred capex.

A key part of the enterprise value of the business will be its real estate. The team’s stadium Old Trafford is 110 years old and one of the most iconic soccer venues in the world. The club also owns large valuable training complexes.

The problem is that they are in a state of disrepair following two decades of under-investment. The current owners the Glazers will want full value for this prime real estate. It is a one of a kind asset after all.

But a buyer will be conscious of hundreds of millions of investment needed to restore the property to its full glory. And they will want some reflection of that in the purchase price.

The buyer reflects the full 'good condition' value of the asset in enterprise value. And then accounts for a debt-like deduction based on the assumed value of delayed maintenance capex. I.e. fixing the roof.

This is a subjective area. And would have manifested as a negotiation over debt-like items.

A simpler example could be deal bonuses and fees. Deal bonuses for the management of the target, would be paid by the target after the deal closes.

But the buyer will expect the seller to pay those bonuses. This gets dealt with by treating the bonus as a debt-like item. This means the seller has paid the buyer to pay the bonuses post closing on their behalf.

Surfacing things that could be ‘debt-like’ items is one of the goals of due diligence. The balance sheet is the obvious place to start. But you also need to use legal and financial due diligence to find other potential future liabilities.

What if a seller refuses to acknowledge a debt like item in the closing statement? Often because they do not believe a liability will materialize.

Then the buyer can push the seller to indemnify them against that liability, through the share purchase agreement. This means that in the event that liability materializes. It is something the seller has to pay, rather than the buyer or target.

This is a good solution for liabilities that are not 100% certain to materialize.

Once the debt like items list is agreed, it is adjusted for $:$ in the enterprise to equity value bridge.

Working Capital

Here we go. The exciting bit. We are going to get technical now.

Working capital by definition is fluid in any business. Even 6 hours before you close a deal, you cannot be certain about what inventory will be at the point of deal closure.

And how do you stop the seller running down inventory as low as possible in the weeks leading up to closing?

What if accounts receivable is full with bad debt?

How do you stop the seller putting a stop on all AP payments for the last month of the transaction? And pushing the liability onto the buyer.

Working capital is full of risk and complexity for buyers.

This only gets worse in a seasonal business.

Imagine you are buying a halloween costume business.

What if 10% of the inventory was faulty, and got returned shortly after halloween?

The buyer needs protection against these risks. The seller wants certainty on their sale.

The risk needs to sit in the right place.

This is a complex, nuanced and judgmental area, but let’s have a go at explaining the principles.

This is commonly resolved through a working capital ‘peg’ and post closing ‘true up’ payment. And the associated accounting policies.

Let’s stick with our halloween costume business as an example.

It’s annual working capital profile might look like this.

• Inventory builds through the year, as the costumes get manufactured.

• Payables are fairly flat as production is consistent.

• Then the inventory is all sold in October ahead of Halloween on 30 day credit terms.

  • Inventory fall, and accounts receivable increase as the target hasn’t yet received the cash.

• Cash is received in November, so the year ends with a lower working capital position.

• The cycle restarts again

Now let’s think about what happens to Net Working Capital (NWC).

NWC = (Accounts Receivable + Inventory - Payables).

It grows over the course of the year, before crashing down in November.

The equity value of this business should vary based on the point in the year when the deal completes.

This is where ‘normalized working capital’ comes in. Also known as the ‘peg’.

The peg is the level of NWC assumed in the enterprise value of the business. There is then a ‘true up’ between the actual working capital at closing date, and the peg.

The start point of the peg, is normally the average NWC for the last twelve months.

Now let’s flip back to Crispy Costumes Inc.

The dotted red line shows the ‘peg’ and the hard red line shows the actual NWC.

A transaction that closes in September, results in the buyer paying the seller extra $ above enterprise value. This would be calculated $:$ as the extra working capital they will be acquiring above the ‘normalized level.’

Where a transaction that closes in December, the reverse is true. The buyer will buy less working capital than the normalized level, and will then get a discount to enterprise value. This will be calculated $:$ as the working capital that gets transferred below the peg.

This is a simple example.

Defining the Peg

Remember, I said, the average of the last twelve months is the start point for the peg.

There is a whole industry in establishing the ‘normalized’ NWC. And whether the average of the last twelve months really is a reasonable?

What if the target has been carrying some one-off levels of elevated inventory for a period? Or there was a bad debt issue in the year that is now resolved? Or we changed suppliers during the year and moved from 30 to 60 day payment terms.

Potentially, your FDD has identified EBITDA adjustments too that have working capital implications. We know these things don’t move in isolation.

There is also a link between debt-like items and working capital assumptions. I.e. if overdue payables get treated as ‘debt-like’, they should be adjusted from the working capital assumptions. They got dealt with elsewhere.

All these would suggest possible adjustments to the peg. To reflect the normalized reality upon closing the transaction.

One of the jobs of the Financial Due Diligence Financial due is to identify adjustments to the peg.

I have had M&A transactions with more than 30 lines of adjustments to the average of the last 12 months definition of NWC.

Why is the peg important?

It goes directly to value.

The seasonal effect of working capital does not. If you buy $10m less working capital than the peg, because of a seasonal low. Sure you get a $10m discount to enterprise value. But you also have to invest that $10m to rebuild the working capital position over the coming months. You are no better or worse off (ignoring a bit of timing)

But if you can move the peg in a direction that favors you. Well, that is real value. It’s as good as a movement in enterprise value.

This, my friends, is where the game gets played.

The seller should want the peg as low as possible.

The buyer should want it as high as possible.

This is quite technical. And can feel a bit of an alien concept in practice.

Sophisticated transaction professionals are all over this. Especially PE. But less experienced M&A dealmakers, often don’t understand this.

ESPECIALLY, if they only start thinking about it at the eleventh hour of the deal.

This is why I used the negotiating technique I outlined at the start. Leave it late, and put in a hard unreasonable position in my favor. It’s not necessarily a winning strategy, but it is a no lose strategy.

One final quirk of working capital in M&A.

Defining Actual Closing Net Working Capital

How do we define what NWC actually is upon closing? There will always be some level of bad debt issues, or inventory provisions required. And a final inventory count is essential.

How does the buyer and seller ever agree on how all this gets treated? And valued?

Well, this gets done in retrospect. After the closing date. Once we have the benefit of an inventory count, a reconciled closing balance sheet, etc.

And when it comes to the definition of the actual NWC upon closing, this time the seller wants this as high as possible. And the buyer as low as possible. Each trying to maximize the NWC true up as far as possible in their favor?

Strange concept, right? This can get very complicated, and multi-faceted. A posiiton you take on a NWC adjustment could undermine a position on an EBITDa adjustment, and vice versa. The deal math is important.

It’s easy to see how the inexperienced get this wrong.

And, how is this all kept in order?

Accounting Policies

The accounting policies section of the share purchase agreement. Here you define the accounting rules that are used to value final working capital in the closing balance sheet.

Local GAAP is the start point, of course. But as we know, accounting is all about judgments. And the basis for how those judgments will be made, get agreed in advance,. So the negotiations here are often on the appropriate departures from GAAP. Or where we want to be more specific on precise assumptions/judgments inside GAAP.

A buyer, for example, would want to be specific about how redundant inventory, or aged receivables get treated. Often carving out specific balances or issues. Pre-agreeing treatments based on defined post completion events.

Even the rules for how inventory gets counted upon closing. Who is present at the count? How do differences get resolved?

Normally the accounting policies will have some sort of hierarchy that says:

• First Priority: Specific accounting policies defined in the Share Purchase Agreement take precedent. (Departures from GAAP)

• Second Priority: Then the accounting practices of the target in the normal course of business

• Third Priority: Then if not defined by 1 or 2 above, local GAAP prevail as a catch all

In that order.

In practice, the buyer will have XX days to prepare a draft of this closing NWC true up. Based upon the accounting policies agreed in the share purchase agreement.

They then send this to the seller who has XX days to accept or contest that position.

This often ends up in a back and forth where there are one of three outcomes:

1. The line by line NWC gets agreed between the buyer and seller

2. It isn’t agreed line by line, but some sort of settlement gets reached

3. Agreement isn't reached, and an independent arbiter resolves the position.

This process gets wired into the share purchase agreement. My experience is that most of the time, the result is 2.

3 is expensive for both parties. I’ve never seen a closing true up go to arbitration in practice. I’ve seen plenty get very close. Often, a settlement is reached once both parties feel like they’ve pushed the other to the limit.

Whoever is the likely debtor, has an incentive to concede to reach agreement. They will want their cash sooner.

Once this gets agreed, the working capital true up is then paid. This can be as long as 6 months (or sometimes more) after the deal has closed.

If the true up is expected to be particularly big (e.g. seasonal business), then the buyer or seller won't want to wait. They may push to include part of that true up forecast into the closing monies.

My strategy on this, is that I never like to be the one out of pocket, in the true up negotiation.

Possession is nine tenths of the law, as they say.

So if I expect to be the ‘debtor’ in a true up negotiation, I will always push to get as much as possible paid upon completion. And if its the other way round, I keep my mouth shut!

So the real game is in the final throws of the deal, negotiating the working capital peg in your favor.

Down if you are a seller, and up if you are a buyer. Whilst, simultaneously agreeing accounting policies that will push closing NWC in your favor. UP if you are a seller and DOWN if you are a buyer.

There is often 1-3% of enterprise value at stake here. Worth having for free, if you can get it.

Fun, right!?

Now, lets zoom right out, and put this together. Considering everything we covered in Week 2, Week 5 and Today. This is how a final equity valuation statement for an M&A transaction could look:

I have seen these run to several pages.

It would not be uncommon to have a schedule of 15-30 adjustments behind each of Adjusted EBITDA, Debt Like Items, Working Capital Peg.

There is an alternative mechanism for closing a transaction which is more seller friendly. This is called a ‘locked box’. I used this recently to get an SMB deal done. But that is another topic in its own right, that I will have to cover another time.

That’s it.

We have cracked valuation!

Boy, that was fun to write.

I hope it was useful.

Last week of the M&A series next week 🥹. We will wrap up by exploring integration, and post deal matters.

THIS WEEK ON TWITTER

Three quarters of a million people saw a chart I made in the bath this week

This made me belly laugh. If you aren’t following Robert … who are you following ???

FEEDBACK CORNER

A review from last time:

These are my favorite reviews. When I hear my content is helping people with something they are working on right now.

There are a bunch of folk creating finance content now, most of it very generic. I’m trying to make sure mine is practical and actionable.

CASHFLOW TIP OF THE WEEK

Anyway …

That’s all for this week. As always you can find me here:

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Next week we will wrap the M&A series with post deal integration.

Until next time…

Stay Crispy,

The Secret CFO

Disclaimer: I am not your accountant, tax advisor, lawyer, CFO, director or friend. Well, maybe I’m your friend, but I am not any of those other things. Everything I publish represents my opinions only, not advice. Running the finances for a company is serious business, and you should take the proper advice you need