What Enterprise Value Includes at Closing

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Business owners often assume the agreed enterprise value represents the amount they will receive at closing. However, enterprise value is only the starting point. In most M&A transactions, buyers value a business based primarily on its expected future earnings and cash flows, discounted for risk. Buyers also expect the operating assets necessary to generate those earnings.

This relationship creates an important connection between enterprise value and working capital. Most lower middle market transactions occur on a cash-free, debt-free basis. Therefore, the seller generally retains excess cash and remains responsible for indebtedness at closing. The buyer, however, still expects to receive a business capable of operating normally after the transaction. That expectation includes an appropriate level of working capital.

Working capital generally consists of operating current assets less operating current liabilities. Depending on the business, these accounts may include receivables, inventory, payables, and accrued expenses. Without sufficient working capital, the buyer could immediately need additional cash to operate the business. Conversely, excess working capital could transfer additional value beyond the negotiated economics.

For this reason, buyers and sellers typically establish a working capital target before closing. The target represents the normalized working capital required to support ordinary business operations. Historical working capital often provides the starting point for this analysis. Yet seasonality, growth, unusual balances, and changing business conditions may require adjustments.

The parties should also define exactly which accounts enter the calculation. Otherwise, disagreements may arise over cash, debt-like items, customer deposits, prepaid expenses, or other balances. At closing, the parties compare actual working capital with the agreed target. A shortfall generally reduces the seller’s proceeds, while an excess generally increases them.

This adjustment does not necessarily change enterprise value. Instead, it reconciles the balance sheet delivered at closing with the assumptions underlying the negotiated purchase price. Accordingly, sellers should understand enterprise value and working capital before signing a Letter of Intent. Waiting until due diligence may create unexpected changes to anticipated proceeds.

An experienced M&A advisor will help establish the appropriate working capital methodology early. The advisor may also coordinate the analysis with the seller’s accounting and legal professionals. Clear definitions prevent working capital from becoming a closing surprise. They also ensure the buyer receives the operating balance sheet contemplated by the transaction.

Maintaining Negotiating Leverage With a Single Buyer

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M&A professionals often say that having only one buyer is similar to having no buyers. The expression highlights the value of competition. Multiple qualified buyers give a seller alternatives and strengthen negotiating leverage. However, even a well-managed sale process may eventually narrow to one credible buyer. When that happens, the seller’s strategy must change.

When the Competitive Process Narrows

A competitive sale process may begin with numerous strategic and financial buyers. Some buyers will decline, while others may withdraw after reviewing the opportunity. Eventually, one buyer may emerge with the strongest interest, strategic fit, financial capacity, and willingness to complete the transaction.

At this point, single buyer negotiating leverage depends less on competing offers. Instead, it depends on understanding the motivations and limitations of both parties. The seller should first understand why the buyer remains interested. Strategic objectives, growth opportunities, synergies, or market expansion, may create compelling reasons to complete the acquisition. Those motivations may become meaningful sources of leverage.

Establish the Seller’s Position

Before advancing negotiations, the seller should define acceptable transaction terms. Purchase price represents only one consideration. Payment structure, working capital, seller financing, earnouts, employment, and closing conditions may materially affect the transaction’s economics.

Above all, the seller should establish a walk-away position before negotiations become emotional. An unacceptable transaction does not become acceptable simply because it represents the only current offer.

Negotiate From a Position of Patience

With only one buyer, the seller should avoid unnecessary urgency. Pressure to complete the transaction may transfer additional leverage to the buyer. Under these circumstances, patience becomes particularly valuable. The M&A advisor should maintain a disciplined process and evaluate each proposed change on its merits.

The advisor should also understand the buyer’s constraints. Buyers may face internal deadlines, financing requirements, acquisition objectives, or other pressures. Seen in that light, negotiating leverage does not disappear simply because competing buyers have left the process.

Protect Leverage Before Exclusivity

The seller generally retains greater flexibility before signing a Letter of Intent. After execution, the buyer receives exclusivity and the negotiating environment changes. Therefore, the parties should resolve major economic terms before signing the LOI whenever possible. Doing so reduces opportunities for unnecessary renegotiation during due diligence.

A single buyer negotiating leverage strategy cannot recreate a competitive marketplace. However, disciplined negotiations may still protect the seller’s objectives. One buyer can produce a successful transaction. The seller simply needs to understand where leverage remains and remain willing to reject an unacceptable deal.

How Working Capital Affects Proceeds at Closing

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Many business sales occur on a cash-free, debt-free basis. However, the buyer still expects sufficient working capital to operate the business after closing. This expectation creates one of the most frequently negotiated components of a transaction: the working capital target.

The target establishes the amount of working capital the seller must effectively deliver at closing. Any difference between actual working capital and the target generally creates a purchase price adjustment.

Defining Working Capital

For transaction purposes, working capital usually includes selected operating current assets and current liabilities. Accounts receivable, inventory, accounts payable, and accrued expenses commonly enter the calculation. Cash and funded debt are typically excluded because the transaction addresses those items separately. Other accounts require careful consideration. Customer deposits, prepaid expenses, deferred revenue, accrued payroll, and related-party balances may create disagreements.

At the negotiating table, the parties should clearly define which accounts belong in the calculation. They should also establish consistent accounting policies for measuring those accounts.

Establishing the Target

The working capital target should reflect the amount reasonably necessary to operate the business under normal conditions. Historical averages often provide a useful starting point. However, the selected measurement period should reflect seasonality, growth, unusual events, and recent operating changes.

A trailing twelve month average may work for one company but distort another company’s requirements. Depending on the business cycle, monthly or quarterly analysis may provide a clearer picture. Sellers should also examine working capital relative to revenue when growth materially affects operating needs. Industry benchmarks may provide context, but company-specific history usually deserves greater weight.

Avoiding Surprises at Closing

Working capital often changes significantly between the LOI and closing. Receivables get collected, inventory moves, vendors receive payments, and new liabilities arise. Accordingly, sellers should model the expected closing balance well before the transaction closes. The LOI should address the working capital methodology whenever possible. Waiting until the purchase agreement may create unnecessary disputes after the seller has granted exclusivity.

An experienced M&A advisor should coordinate the analysis with the seller’s accounting and legal advisors. The team should define accounts, identify unusual balances, and establish a defensible target. A properly structured working capital target helps ensure the buyer receives a normally operating business. It also protects the seller from an unexpected reduction in proceeds at closing.

Managing Due Diligence After the Letter of Intent

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The execution of a Letter of Intent marks a significant transition in the M&A process. At that point, the selected buyer typically receives exclusivity. The seller stops discussions with other prospective buyers while the selected buyer completes confirmatory M&A due diligence. Therefore, the transaction enters a different negotiating environment.

Before the LOI, multiple buyers may compete for the opportunity. That competition may strengthen the seller’s negotiating position on price, structure, and other terms. After exclusivity begins, that competitive pressure disappears. The buyer then conducts an extensive review before signing the definitive purchase agreement and closing the transaction.

The primary purpose of confirmatory M&A due diligence is to verify the information presented during the sale process. Buyers also investigate risks that could affect their investment. The review generally covers several major areas:

  • Financial: Revenue, earnings, normalized EBITDA, working capital, receivables, inventory, debt, and financial projections.
  • Legal: Contracts, corporate records, litigation, intellectual property, licenses, insurance, and regulatory compliance.
  • Operational: Facilities, equipment, technology, systems, suppliers, processes, and capital expenditure requirements.
  • Commercial: Customers, concentration, retention, pricing, competition, market position, and growth opportunities.
  • Human Resources: Management, employees, compensation, benefits, agreements, and organizational structure.
  • Tax: Income, payroll, sales, property, and other applicable tax matters.

The buyer may also conduct specialized reviews involving cybersecurity, environmental matters, insurance, or other industry-specific risks. During diligence, the buyer compares its findings with the information provided before signing the LOI. Significant differences may create problems for the seller. For example, declining earnings may challenge the assumptions supporting the purchase price. Customer losses or unexpected liabilities may create similar concerns.

In response, the buyer may seek a price reduction, additional escrow, stronger indemnification, or other changes. Significant findings may also prevent the transaction from closing. This possibility makes preparation before the LOI critical. Sellers should identify potential diligence issues before prospective buyers evaluate the company.

Financial statements should reconcile with supporting records and income tax returns. Contracts, employee matters, customer concentration, ownership records, and other significant issues should receive similar attention. When possible, the seller should correct problems before beginning the sale process. Otherwise, material issues should receive appropriate disclosure before the buyer receives exclusivity.

This approach protects credibility and reduces the likelihood of unexpected discoveries during confirmatory M&A due diligence. It also helps preserve the economics negotiated during the competitive process.

An experienced M&A advisor should anticipate diligence issues well before selecting a buyer. Careful preparation allows confirmatory diligence to validate the transaction rather than become an opportunity to renegotiate it.

Private Capital Markets: Is Now the Time to Sell?

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The private capital markets are experiencing strong transaction activity, favorable valuations, and significant demand for quality middle market companies. For business owners considering an exit, current conditions deserve careful attention. Robert T. Slee, an investment banker and influential author, examines private market cycles in Private Capital Markets: Valuation, Capitalization, and Transfer of Private Business Interests. Slee’s research suggests that U.S. private markets operate within approximately ten-year transfer cycles.

According to this framework, the market currently favors sellers. Strong earnings, available financing, and significant buyer demand continue to support attractive valuations for quality businesses. However, favorable market conditions rarely continue indefinitely. Slee’s market-cycle analysis suggests this seller’s market may begin weakening toward the end of 2017. Thereafter, the market could enter a period of uncertainty through approximately 2020. The framework anticipates a buyer’s market following that neutral period. Under this scenario, weaker conditions could continue through approximately 2023 before the cycle begins strengthening again.

Meanwhile, several factors continue supporting today’s active M&A environment.

Private equity groups maintain substantial capital (“dry powder”) available for acquisitions and continue pursuing quality companies. In particular, they seek businesses with sustainable cash flows, strong management teams, defensible market positions, and meaningful growth opportunities. At the same time, strategic buyers continue using acquisitions to supplement organic growth. Acquisitions may provide immediate access to customers, geographic markets, products, technologies, employees, and other strategic capabilities. Demographic trends create another important consideration within the private capital markets. A significant population of middle market business owners are approaching traditional retirement age. Consequently, more owners may pursue liquidity and succession strategies during the coming years.

An increasing supply of businesses for sale could eventually affect market dynamics. More sellers competing for buyer attention may place pressure on valuations, particularly if economic conditions or financing markets weaken. For business owners, these trends reinforce the importance of early exit planning. Preparing a company for sale may require several years of deliberate work. Owners should strengthen earnings, develop management, diversify customers, improve financial reporting, and address identifiable business risks. They should also establish realistic valuation expectations and clearly define their personal and financial objectives.

No business owner can perfectly predict the next market cycle. Nevertheless, understanding conditions within the private capital markets will help owners make informed decisions about timing. For owners considering an exit within the next several years, 2016 provides an important opportunity to evaluate their alternatives. Early preparation creates flexibility and positions owners to act while market conditions remain favorable. Whether it’s selling to a private equity group, a strategic, or watching your “baby” flourish, Allston Advisory Group has the experience to assist you with the desired transaction for your business.

Choosing the Right Process to Sell a Business

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Preparing a company for sale may significantly improve its financial performance, reduce risk, and strengthen its value drivers. For many businesses, this preparation has the greatest influence on transaction value. Once the company is ready for market, the business sale process becomes another significant factor in the outcome. The process determines how prospective buyers encounter the opportunity, compete for it, and negotiate transaction terms.

A well-designed process may create competitive tension while protecting confidentiality and preserving negotiating leverage. It may also help the seller identify which buyers place the greatest value on the business. The appropriate approach depends on the company, buyer universe, market conditions, and seller’s objectives. Most lower middle market transactions generally follow one of three approaches.

Broad Auction

A broad auction introduces the company to a relatively large group of qualified prospective buyers. These buyers may include strategic acquirers, private equity firms, family offices, and other financial buyers. This approach works particularly well when many credible buyers could have an interest in the company.

With a wider field, the seller may compare multiple offers and allow competition to influence price and transaction terms. However, broader outreach also requires careful confidentiality controls. The M&A advisor must qualify buyers and manage information throughout the process.

Targeted Auction

A targeted auction focuses on a smaller group of buyers with compelling reasons to pursue the company. The advisor identifies prospective buyers based on strategic fit, acquisition criteria, financial capacity, and likely interest. Through this narrower approach, the seller may preserve many benefits of competition while limiting unnecessary market exposure. A targeted auction may work especially well when the likely buyer universe is identifiable or confidentiality requires greater control.

Negotiated Sale

A negotiated sale involves discussions with one buyer or a very limited group of buyers. This approach sometimes begins with an unsolicited offer from a strategic acquirer. The process may offer greater confidentiality and potentially move faster. However, limited competition may reduce the seller’s negotiating leverage. In this situation, the seller must understand the company’s value and establish acceptable transaction terms before granting exclusivity.

Matching the Process to the Seller

No single business sale process works for every company. The appropriate strategy depends on buyer demand, confidentiality, market conditions, and seller objectives. An experienced M&A advisor should evaluate the likely buyer universe before recommending an approach. The advisor may then structure the process around the company’s specific circumstances.

A strong company creates value. The right sale process gives the marketplace an opportunity to recognize and compete for that value.

Using KPIs to Build a Stronger and More Valuable Business

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Business owners cannot manage their companies effectively without understanding what drives financial and operational performance. Financial statements provide essential information, but they primarily explain what has already happened. Business performance indicators help management anticipate what may happen next. Key Performance Indicators, or KPIs, measure the activities and results that matter most to a company’s success.

Start With Financial Performance

Every owner should regularly review the income statement, balance sheet, and cash flow. However, reviewing individual months provides only part of the picture. Management should compare current results with budgets, prior periods, and historical trends. Industry benchmarks may also provide useful context when reliable comparisons exist.

Financial KPIs may include revenue growth, gross margin, EBITDA margin, days sales outstanding (DSO), and working capital. Alongside these measures, owners should identify the operational factors that produce financial results.

Identify Leading Indicators

Some of the most valuable KPIs appear before changes reach the financial statements. A contractor might monitor backlog, bids submitted, win rates, and project margins. A service company might track recurring revenue, customer retention, utilization, and new customer acquisition. A manufacturer could monitor capacity utilization, scrap rates, throughput, order volume, and on-time delivery. Earlier in the performance cycle, these indicators can provide warning signs or identify emerging opportunities.

Owners should ask a simple question: What would change first if our business started getting better or worse? The answer often identifies the company’s most useful leading indicators.

Turn Information Into Action

Tracking KPIs creates little value unless management acts on the information. Companies should establish targets, assign accountability, and review results consistently. Management may then investigate meaningful variances and determine appropriate responses.

When patterns emerge, leaders may adjust pricing, staffing, inventory, marketing, capital spending, or other operating decisions. A concise dashboard may keep management focused on the measures that matter most. Too many KPIs may obscure meaningful information rather than improve decision-making.

KPIs Support Business Value

Buyers want to understand more than historical earnings. They also want evidence explaining how the company generates those earnings. Well-developed business performance indicators demonstrate operating discipline, management depth, predictable performance, and visibility into future results.

For an owner preparing for a sale, KPIs can also strengthen the company’s investment story. They provide measurable evidence supporting growth trends, competitive advantages, and future opportunities. An experienced M&A advisor should identify the KPIs that prospective buyers will find most relevant. The advisor may then analyze historical trends and connect operating performance to the company’s financial results.

As sale preparations advance, the advisor may incorporate these measures into the Confidential Information Memorandum and other buyer materials. This analysis helps buyers understand what drives revenue, margins, and future earnings. KPIs also support management projections by connecting forecasted results to measurable operating assumptions. During due diligence, consistent KPI reporting help validate those assumptions and explain changes in performance.

An M&A advisor may also identify unfavorable trends before buyers discover them. Management then has time to investigate the causes, address problems, and prepared credible explanations. Strong businesses do not simply report financial results. They understand the operating factors behind those results. An experienced M&A advisor uses KPIs to help buyers understand those drivers and recognize the value they create.

Why the Purpose of a Business Valuation Matters

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Business owners often ask what their companies are worth. However, that question does not have one answer for every circumstance. The purpose of a business valuation helps determine the appropriate engagement, standard of value, assumptions, and level of analysis. A valuation prepared for estate planning may differ significantly from an analysis supporting a potential business sale. Likewise, litigation or shareholder matters may require different assumptions and standards.

Different Decisions Require Different Valuations

Business valuations serve many financial, legal, tax, and transaction purposes. Common applications include estate and gift planning, shareholder transactions, buy-sell agreements, litigation, and employee ownership plans. Valuations may also support charitable contributions, purchase price allocations, and other financial decisions.

Given these different purposes, owners should define the valuation question before beginning the analysis. The applicable standard of value may include fair market value, fair value, or investment value. Each addresses a different question and may produce a different conclusion.

Valuation Before a Business Sale

A preliminary business valuation establishes a reference point for current value. It may also reveal a gap between estimated proceeds and the owner’s financial objectives. When a gap appears, the owner may decide that additional preparation is necessary before pursuing a transaction.

At that point, an Exit Readiness Assessment may provide a broader evaluation of the company from a prospective buyer’s perspective. The assessment may examine earnings quality, growth, customer concentration, management depth, operations, and other significant value drivers.

Together, the valuation and Exit Readiness Assessment serve different but complementary purposes. The valuation establishes where the business stands financially. The Exit Readiness Assessment helps identify what the owner should address before going to market.

Buyers May See Different Values

Prospective buyers do not necessarily value the same company equally. A financial buyer may focus heavily on expected returns and financing capacity. A strategic buyer may identify synergies, capabilities, customers, or geographic opportunities unavailable to other buyers. Because buyer economics differ, a valuation should not establish an artificial ceiling on transaction value. A competitive sale process allows multiple buyers to evaluate the company from their own perspectives.

Selecting the Appropriate Engagement

Qualified valuation professionals may perform different types of engagements depending on the assignment. A valuation engagement develops a conclusion of value after applying appropriate valuation approaches and methods. A calculation engagement uses agreed approaches, methods, and procedures to develop a calculated value.

An experienced M&A advisor uses valuation analysis to help owners establish expectations and prepare for a potential transaction. Understanding the purpose of a business valuation comes first. The appropriate analysis should answer the owner’s specific question rather than produce a number without context.

From Letter of Intent to the Definitive Purchase Agreement

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After completing confirmatory due diligence, the parties move toward finalizing the purchase agreement. This definitive agreement governs the transaction and establishes each party’s binding obligations. The Letter of Intent provides the framework for these negotiations. It generally outlines purchase price, structure, consideration, working capital, and other principal business terms. The purchase agreement goes considerably further. It converts negotiated terms into detailed contractual provisions and addresses risks identified during due diligence.

Although transaction attorneys draft and negotiate the agreement, many provisions involve significant business decisions. Sellers should therefore understand the economic consequences behind the legal language. A typical purchase agreement addresses three broad areas:

  • Transaction Economics: Purchase price, consideration, payment timing, earnouts, seller notes, rollover equity, and post-closing adjustments.
  • Closing Mechanics: Closing conditions, required consents, covenants, financing requirements, schedules, and procedures for completing the transaction.
  • Risk Allocation: Representations, warranties, indemnification, escrows, holdbacks, baskets, caps, survival periods, and dispute procedures.

The agreement also defines exactly what the buyer acquires. In an asset sale, it identifies purchased assets and assumed liabilities. By comparison, an equity transaction transfers ownership interests in the legal entity. The agreement must still address excluded obligations and other negotiated protections.

Working capital frequently receives significant attention during negotiations. The agreement establishes the target, calculation methodology, and process for resolving post-closing differences. Representations and warranties serve another purpose. They provide factual statements about the company, its operations, financial condition, contracts, employees, taxes, and other matters. Disclosure schedules then qualify those representations by identifying exceptions. Accurate schedules help sellers disclose known issues and reduce potential post-closing disputes.

Once negotiations reach this stage, the transaction attorney takes the lead on legal documentation. However, the attorney should not work independently from the broader M&A team. The M&A advisor helps ensure the agreement accurately reflects the business terms negotiated in the LOI. The advisor also evaluates proposed changes affecting purchase price, consideration, working capital, and other economics. Meanwhile, the seller’s CPA and tax advisor evaluate accounting and tax provisions. Their input may become particularly valuable when addressing allocations, working capital, and transaction structure.

New issues may still emerge before closing. When they do, the advisory team should evaluate their legal, financial, and economic consequences together. A well-negotiated purchase agreement does more than document the sale. It preserves negotiated economics, allocates transaction risk, and establishes clear obligations through closing and beyond.

Creating Buyer Competition in a Business Sale

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A business owner negotiating with one buyer has limited information about what the broader marketplace may offer. The buyer knows this as well. A competitive buyer process changes that dynamic by creating alternatives for the seller. Multiple qualified buyers strengthen negotiating leverage and provide meaningful comparisons among offers. However, generating a long buyer list does not create competition by itself. The M&A advisor must identify buyers with the interest, resources, and strategic rationale to complete the transaction.

Build the Right Buyer Universe

The process begins by understanding the company and identifying potential sources of buyer demand. Strategic buyers may seek new customers, geographic markets, products, employees, technology, or operating capabilities. Private equity firms evaluate opportunities based on their investment criteria, portfolio strategies, expected returns, and available capital. Well-funded individual buyers and family offices may also represent credible candidates for certain companies.

At the buyer-development stage, the advisor should look beyond obvious industry participants. Buyers from adjacent markets may identify opportunities that direct competitors overlook.

Qualify Buyers Before Sharing Information

More buyers do not necessarily create a better process. Qualified buyers do. An experienced M&A advisor should evaluate financial capacity, acquisition criteria, transaction experience, strategic rationale, and decision-making authority. This qualification helps separate serious prospects from tire kickers.

After establishing credibility, qualified buyers receive the Confidential Information Memorandum (CIM) following execution of a confidentiality agreement. The CIM should present the company’s financial performance, operations, competitive position, and growth opportunities clearly.

Create Competition Through Process

Competition requires more than contacting buyers. The advisor must manage those buyers through a coordinated process. Deadlines for indications of interest encourage buyers to make decisions within a defined timeframe. Comparable offers also allow the seller to evaluate price, structure, certainty, and post-closing terms.

As buyer interest develops, the advisor negotiates from a position supported by credible alternatives. One buyer may offer the highest price. Another may provide more cash, fewer contingencies, or better terms for the seller.

Preserve Competition Until the LOI

The seller’s leverage generally reaches a critical point before granting exclusivity to one buyer. An experienced M&A advisor should use the competitive buyer process to resolve significant economic terms before that occurs. The objective is not simply to generate multiple buyers. It is to create a marketplace where qualified buyers compete for the opportunity.

Competition gives the seller alternatives, and alternatives create negotiating leverage.

Allston Advisory Group is an experienced boutique M&A advisory firm providing a variety of services to lower middle market companies. See our footer for contact information.

(502) 742-2933
[email protected]
P.O. Box 21266, Louisville, KY 40221

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