How the buyer calculates the selling price of a company
To understand the true purchase or sale price of a company, it is important to understand what is meant by the terms “enterprise value” and “equity value” or “share value” or “enterprise price” and how they differ. Value and price are often used interchangeably, but the two concepts are not synonymous. It is important that the negotiating parties to a sale and purchase use the terms correctly.
Most company sales processes are initiated by establishing a sales price, which is referred to as the enterprise value. Typically, enterprise value is calculated using a method based on EBITDA multiples, supported by an analysis aimed at determining free cash flow. This enterprise value does not take into account the financial structure of the business. The aim of this first approach is to understand the gross value of the business generated by the company. Thus, the enterprise value does not include any adjustment for debts or for possible surpluses or cash needs. However, the buyer will take these aspects into account and will adjust the enterprise value for the effects of financial debt and cash.
how is the selling price of a company set?
When a company is bought, the price is set on the basis that it is acquired without any financial debt. This means that the seller should be liable for all the company’s financial debts (bank debt, leasing, loans to shareholders, outstanding dividends, etc.).
In practice, the amount of the outstanding financial debt is subtracted from the purchase price. Conversely, if the company has cash in excess of that needed to carry out its ordinary activities, the seller may dispose of this excess non-operating cash and add it to the sale price, or withdraw it in the form of dividends before the closing of the transaction. Thus, on the first gross value of the company calculated at the beginning of the process, the buyer, in order to establish the purchase price, will adjust that value downwards for the outstanding financial debt and add any excess cash the company may have.
Precisely, one of the most controversial elements when calculating the excess cash attributable to the seller is to calculate the minimum level of operating cash that the seller must leave in the company to maintain the ordinary activity. In this regard, it is common practice to calculate this operating cash as an average of the company’s cash requirements over the last 12 months.
However, it is necessary to analyse each company in detail as it may be that we find companies with higher cash requirements at specific points during the year, or cases in which the business model is seasonal.
Finally, once the value of the company has been adjusted to take into account the company’s financial debt and excess cash, we can obtain the price of the company or the price of the shares that the seller would finally receive.
It is therefore important not to confuse the raw value of a company with the final price that a buyer is willing to pay for it, since, as we have explained, a series of upward and downward adjustments must be taken into account, which require significant technical analysis and, moreover, are aspects that are always subject to negotiation.