The Forgotten Balance Sheet

When valuing a business, most company owners are worried about the income statement. Here is a typical example: A business owner projects normalized EBITDA to be $5 million, and after applying a multiple of 5 times, the enterprise value of the business arrived at $25 million. Interest-bearing debt of $5 million is deducted from the enterprise value in order to arrive at the equity value of $20 million. Done, right? Not quite! Experienced valuators and investment bankers always consider the balance sheet.

In most cases, a balance sheet is not given adequate consideration prior to a transaction. However, the balance sheet sets out critical information about the financial strength and weakness of the company. As a general rule, the stronger the balance sheet, the higher the value of the company. The higher value is normally reflected in two ways: The first is a higher valuation multiple applied to the company’s EBITDA and the second is a price adjustment clause (PAC).

A common misconception some business owners have is the belief that they should receive extra value for the net operating assets on the balance sheet (e.g. accounts receivable, inventories and other operating assets, net of liabilities) over and above the equity value of the company. However, the normal convention involving mid-market and large privately held companies is that the buyer receives the seller’s balance sheet as part of the purchase price. The rationale is that a base level of working capital and other operating assets is required to generate the expected EBITDA.

The balance sheet delivered to the buyer on closing is normally subject to negotiation, but would typically include the net working capital and other assets required to support the ongoing operations of the business. An adjustment to the purchase price is a common practice (PAC), where the amount of working capital delivered to the buyer is greater than (or less than) what is negotiated. An adjustment to the purchase price is also made where redundant assets are sold with the business. Redundant assets are those assets that are not required in the ongoing day-to-day operations of the business.

In order to maximize shareholder value, business owners should not only seek to demonstrate growing revenues and earnings, but also to manage the assets and liabilities of their company prior to ownership succession.