Understanding “Enterprise Value”
and “Equity Value”
When business owners discuss valuations, they sometimes use the term “price.” However, there is an important distinction in business valuations between “value” and “price.” In business valuations, practitioners usually prepare a notional determination of “fair market value.” In addition, a notional determination of value is typically first approached on a “debt-free, cash-free” capital structure, with additional adjustments as discussed later in this article.
Fair market value is typically considered to represent the highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, each acting at arms-length in an open and unrestricted market, when neither is under compulsion to buy or to sell and when both have reasonable knowledge of relevant facts.1
When discussing business value with owners, one key area that is often misunderstood is the difference between the “enterprise value” and “equity value.” In order to understand the distinction between the two, it is important to consider the definition of fair market value above, and how it is calculated.
Most operating businesses are valued on a going concern basis, which means the business is assumed to continue to operate for the foreseeable future. This is because in most operating businesses, the value of the future economic benefit generated is greater than the value of the underlying assets employed in the business operations. When this is the case, the value of the overall business enterprise is greater than the value of its underlying assets and liabilities, and therefore a buyer would be willing to pay more to purchase the business altogether instead of the individual assets and liabilities separately.
One of the primary going-concern approaches to valuing a business is to employ a cash flow or earningsbased valuation methodology, which values the business based on its ability to generate future cash flows. Common cash flow-based valuation methodologies include applying a multiple to either the business’ sustainable level of cash flow or EBITDA (earnings before interest, taxes, depreciation, and amortization) when earnings are relatively stable, or when changes are expected through a discounted cash flow analysis, where annual future cash flows are discounted based on the risks related to the business, as well as the timing of when the results will be achieved.
What is Enterprise Value?
The above mentioned cash flow/earnings based valuation methodologies each result in the calculation of Enterprise Value, which is the total economic value attributable to the business enterprise, regardless of how it was financed (i.e., debt and cash) or its share structure. Enterprise Value is the “debt-free, cash-free” concept introduced earlier and can also be thought of as the value available to all debt providers, common shareholders, preferred shareholders, etc. Because Enterprise Value represents the business before financing and other discretionary amounts, it does not include the value of cash, non-operating assets or liabilities, or shareholder loans since they are not part of normal business operations.
What is Equity Value?
Equity Value is the value attributable to the shareholders’ equity of the business, including all preferred and common shareholders. In other words, is the value available after any payment to creditors and other non-equity stakeholders. The Equity Value of a business is determined by subtracting outstanding debt and other non-operating liabilities from the Enterprise Value of the business and adding any cash and redundant other non-operating assets.
The distinction between Enterprise Value and Equity Value is not always widely understood. Often, when a business is sold an initial offer is made on a cash-free and debt-free basis or Enterprise Value. In reality, at closing, any debt is deducted from the original price and the value of cash and other redundant assets may be added to come to a final price that is paid for the shares or Equity Value of the business. Another important consideration is the normal working capital requirements of the business, as the extent that there is too much or too little working capital in the business may lead to another significant adjustment. As a result, the working capital needs of the business should be carefully analyzed because this can be a dollar-for-dollar adjustment to the Equity Value, which we will discuss in detail in a subsequent article.
Implications for Business Owners
When discussing business value, owners may not appreciate some of the key differences between Enterprise Value and Equity Value. A common misunderstanding is related to the impact on Equity Value from shareholder/related party loans. Owners often move cash in and out of their corporations for risk management and other purposes. When a business begins, the owner or key investors will lend funds to the newly formed corporation in the form of a shareholder loan or loan from a related company. As a business matures, dividends may be declared and then loaned back to the business for operational purposes. When valuing the shares or equity of a corporation that has loans from shareholders or other related parties, the value of these loans must be deducted from the Enterprise Value of the business along with any other debt and non-operating assets and liabilities. However, it is important to note that the shareholder loans would typically be paid out on a tax-free basis, because these loans were made by the shareholders with after-tax dollars. As a result, owners or sellers should have an understanding of the after-tax proceeds in a potential transaction.
Business owners also often ask about non-operating or redundant assets held in a business, which also impact the Equity Value. Some common examples of these assets include excess cash, marketable securities, real estate, personally used vehicles, and loans receivable (including from shareholders or other related parties). Since these assets do not relate to the ongoing business operations, their values are added to the Enterprise Value in determining the Equity Value.
Identifying redundant/non-operating assets is an important step when preparing a business for sale. Generally, potential buyers are not interested in purchasing these redundant assets or will not pay for their full value since they are most interested in the core operations. When this is the case, it is typically better for the owner to sell or transfer these assets out of the business prior to closing a sale. However, it is not always easy to carve out redundant assets or liability when a business is sold and it is therefore important to understand these items if considering a sale transaction and to work with the appropriate advisor.