Hypothetical Valuation Question
Hi all, had a hypothetical question in mind.
Assume that at the start of my business, I purchased a building (financed 50% by debt), which I have determined to be my main place of operations and as such do not need to pay rent as I own the building.
Fast forward to today, I am considering to sell my business. However, as the building has appreciated greatly in value, I am intending to solely sell my business and retain ownership of the building.
Question: What adjustments do I need to make to cashflows and valuations (if any)? For example, do I need to adjust for additional rental expense since the acquirer will now need to pay for rental expense (which leads to a lower valuation due to lower cash flows), or do I need to subtract out net debt or value of the asset/building from the implied enterprise value?
Appreciate any guidance on this, thanks!
When considering the sale of your business while retaining ownership of the building, several adjustments to cash flows and valuations are necessary to reflect the new operational structure for potential acquirers. Here's a breakdown based on the most helpful WSO content:
Adjust for Implied Rental Expense: Since the acquirer will need to pay rent for the building you're retaining, you should adjust the business's cash flows to reflect this additional expense. This adjustment will likely lower the business's valuation due to the impact on net cash flows. The implied rental expense should be estimated based on market rates for similar properties in the area.
Subtract Net Debt: In valuing the business for sale, you should subtract any outstanding net debt from the implied enterprise value. This adjustment accounts for the debt financed portion of the building purchase and any other liabilities the business may have. The resulting figure will give you a clearer picture of the equity value of the business.
Consider the Impact on EBITDA: The addition of rental expense will also affect the EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) of the business. Since EBITDA is a common metric used in business valuations, particularly for calculating multiples, this adjustment will directly impact the valuation.
Asset Valuation Adjustment: If the building represents a significant asset on the business's balance sheet, its removal (since you're retaining ownership) will require an adjustment to the asset valuation of the business. This adjustment reflects the fact that the acquirer is not purchasing the building as part of the deal.
Future Cash Flow Projections: Adjust your future cash flow projections to account for the rental expense and any changes in operational efficiency or cost structure that might result from not owning the building. These adjusted cash flows should be used in any discounted cash flow (DCF) analysis to value the business.
Communicate Clearly with Potential Acquirers: Transparency about the operational changes and the impact on the business's financials is crucial. Clearly outline the adjustments made and the rationale behind them to potential acquirers to ensure they have a complete understanding of the business's valuation and future cash flow expectations.
By making these adjustments, you can provide a more accurate and fair valuation of your business that accounts for the change in operational structure post-sale. This approach ensures that both you and the potential acquirer have a clear understanding of the financial implications of the transaction.
Sources: Working Capital considerations in LBO, https://www.wallstreetoasis.com/forum/investment-banking/need-help-with-cashflow?customgpt=1, Breaking Into Commercial Real Estate, Valuing a small privately held services company, Personally Buying a Small Business - Quitting the Rat Race
You should make a projection of rental expense in your financial model. If you don’t, buyside investors would incorporate rental expense in their model anyways which would lead to lower cash flows, and ultimately, lower Enterprise Value.
The buyside’s financial due diligence team would also add hypothetical rental expense to your historical EBITDA, so that both the normalized historical EBITDA and the projected EBITDA are apple to apple. Again, if buyside investors use the EV/EBITDA multiple approach, this would also lead to a reduced Enterprise Value.
Lastly, you would normally add the building to the Equity Bridge since it’s a non-operating asset and it’s treated as a cash-like item. Therefore: Enterprise Value + Building - Net Debt = Equity Value. This is only if you sell the business together with the building. However, since you’re selling the business without the building, you’d perform a carve-out pre-closing, and the formula now becomes Enterprise Value - Net Debt = Equity Value. This new Equity Value is what you’d get in your bank account on the transaction closing day.
As for the Debt associated with the Building, normally you'd carve that out too, meaning that you'd adjust the Net Debt as well as Interest Expense on your 3-statement model.
Thanks for the help, just had a few questions
1) When factoring in the additional rental expense to arrive at my pro forma statements and cash flows, do I still need to do any adjustments in my equity bridge or will that be double counting?
2) Regarding the carve out pre closing mentioned, do you mean I just ignore the value of the building when doing the Equity Bridge?
3) Regarding the debt associated with the building, what do you mean by adjusting the net debt? Assuming my total net debt is $100 with the debt due to the building amounting to $40, does that mean I only subtract $60 of debt from the Equity Bridge?
4) The formula above does not seem to have taken into account the equity I own in the building. Since the building is financed 50% by debt, meaning the remaining 50% is owned through equity. I would imagine this needs to be removed someone from the Equity Bridge since the acquirer would not be paying for this portion?
1) The only place where the rental expense should appear is on the IS, which then affects the CFO and C&CE balance on the BS.
You only include BS items, off-BS items, and contingent liabilities on the Equity Bridge (things such as excess cash, borrowings balance, debt-like items, cash-like items etc.) Basically, any items that have not been accounted for in the FCFF when deriving TEV (a good rule of thumb is any items included in EBITDA are already accounted for in FCFF).
If you don't include rental expense on the IS, then you could theoretically add "Rental Payable" (= NPV of Rental Expense forever) to Net Debt which does the same thing: Equity Value will decrease. But don't do both as this is double counting.
2) Correct. If you add Building in, then Equity Value increases, which means that the Buyer has to pay more for something that they will not receive.
3) Correct. Let's say the TEV is $200, total Net Debt is $100, Debt of Building is $40, Building is $80.
Scenario 1: You sell Business + Building -> you receive: $200 - $100 + $80 = $180 in Cash
Scenario 2: You sell Business only, you leave all Debt to the Buyer -> you receive: $200 - $100 = $100 in Cash and Building worth $80
Scenario 3: You sell Business only, you carve out the Building and its associated Debt -> you receive: $200 - $60 = $140 in Cash, Building worth $80, and Debt of $40.
Do you see how your net worth is still the same in all 3 scenarios?
4) The "Equity in the Building" is already captured in the Common Shares you raised to buy the Building -> it is not either Cash-like or Debt-like so there's no need to make any adjustment.
Let's say you have 2 exact same businesses A & B with the same TEV of $200 and Net Debt of $60. Now, for B, you raised $40 of your own equity, took another $40 debt, and purchased a Building for $80.
If you sell A: you get $200 - $60 = $140
If you sell B and carve out the Building + Debt: you get $200 - $60 = $140 in cash, a Building worth $80, Debt of $40, and you also previously put in $40 cash yourself. So in both cases, your net worth is still the same and the Buyer still pays the same amount.
In your example, why would you sell the business rather than the building or rather the entity incl the building?
Aspernatur officia voluptatem perspiciatis mollitia ut qui et. Numquam repellendus aspernatur ea necessitatibus animi quos. Corrupti itaque qui dicta repudiandae est. Commodi harum numquam blanditiis dolorem quod quia est. Praesentium quod rerum quia voluptatibus tempore molestiae quas. Eligendi qui veniam eligendi reiciendis maiores facere. Possimus voluptatem voluptas enim id qui provident voluptatem tempora.
Accusantium enim et officiis vitae quis quibusdam itaque. Iure veniam id est eligendi. Voluptatem et et unde ut aut porro. Deleniti ipsam sit recusandae ea ad magnam ipsa.
Sit vel similique provident. Quibusdam dolorum aut quis molestiae deserunt. Tempore amet accusamus nobis temporibus. Quibusdam eos eligendi non similique magnam. Neque rerum et optio temporibus voluptates. Facere possimus rerum temporibus aut quos ipsa. Quos quis unde dolorem.
Fuga ad iste velit libero fugiat voluptatum explicabo. Nulla unde quidem fugit at. Enim laboriosam iste laborum beatae enim. Qui quisquam amet qui architecto omnis dicta. Sed nam quo eius minima enim. Sint neque soluta quisquam reiciendis ut et.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...