Treatment of cash in valuation - who's right?

So I've a friend of mine, with whom I am in conflict about the treatment of cash in a purchase. He's someone who has been part of company sales a few times from a strategic perspective (as an entrepreneur), but typically in the smaller case stuff, say, under 20M (I believe).

He is absolutely convinced that the total amount paid for a company is [EV+seller cash]; his reason being that "enterprise value is derived from EBTIDA, but that's separate from the cash they have in the books". He backs this up by volunteering that idea that a company with an EBITDA of 20, a multiple of 5x, and cash of 500 cannot possibly be worth the same as a company with EBITDA 20, a multiple of 5x, and cash of 50; that any company worth it's salt would simply have it's owners take that 500 for themselves vs a buyout valuation of 100 (for sake of argument we were discussing sole ownership). Cash, in his argument, has to be treated separately from the EBITDA flow, and purchase of a company does not include purchase of it's cash. He claims to have seen this happen following a purchase for some of his companies, that there is further negotiation to buy the cash holdings after the company was bought.

I said this makes no sense; that EV, by itself, was going to be basically within a few % of the actual money paid out to a company. I mentioned that cash is taken out of a non-multiple calculation of EV exactly because it's totally now owned by the buyer, and thus makes their purchase "less expensive"; that cash on the balance sheet is in no way the same as the personal holdings of the owners even if they've complete control of the company; that balance sheet assets aren't actually part of the total money paid out valuation at all; that the enterprise value already intrinsically includes the cash holdings of the company as a non-operational means to generate the EBITDA which forms the basis for the multiple; that a company with massive cash holdings isn't worth that much more just because they've cash but in fact raises eyebrows because they've not been utilizing their cash as efficiently as they could.

I've never once seen a secondary negotiation to buy cash holdings from a seller following a purchase of that seller.

He remains supremely unswayed, and asks again: why would a company with 20 EBITDA/5x/500 cash be bought for the same amount of money as a company with 20 EBITDA/5x/50 cash. A house worth 1M and a basement full of gold isn't going to get bought for the same price as a house worth 1M and no gold.

Has anyone seen such a thing? Who is right in this scenario? What would be a convincing, easy analogy to explain that the company with 500 cash is in fact going to be bought for the same price as the company with 50 cash (assuming I'm right)?

EDIT: I am in the wrong on this one, and as such have changed the title.

Comments (17)

Jan 27, 2020

Enterprise value represents the value of a company to all stakeholders (equity and debt) rather than the seller of a company (just equity). The value to a seller is the enterprise value - net debt, and in the case that you have more cash than debt this means that the sellers will receive a sum > enterprise value. When you calculate Enterprise value you subtract the cash and add the debt of a business (as well as some other stuff, but let's forget that for now).

In essence enterprise value is what a business will cost to acquire (what you need to pay to both equity and debt holders - what cash you receive). Going backwards, if we assume that debt on both companies is 0, your equity value will be as follows.

Company 1: EBITDA 20 * 5x = 100 + 500 cash =1500 Equity value
Company 2: EBITDA 20 * 5x = 100 + 50 cash = 1050 Equity value

In this case company 1 shareholder's/sellers will receive more cash, but it will cost the acquirer the same amount of money. You can think of it as if you were buying a car. The first car salesman says he can sell you the car for $10,000 but he'll offer a company rebate of $2,000. The second salesman says he can go as low as $9,000, but he'll only offer you a $1,000 rebate. In both cases, you're going to end up with a new car and out $8,000.

TL;DR: Your friend is correct.

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Jan 27, 2020

Ah! Thank you for the breakdown. It makes sense that way, that one would have the equity value of 600 vs 150.
Still, while I can appreciate the mathematical distinction, I can't say I've ever seen this sort of thing occur. Which isn't to say it doesn't, but why does valuation conceptually worry about enterprise value so much in comparison? If the buyer wanted the totality of the holdings of the seller, as they so often do, wouldn't they need to have a secondary negotiation to purchase the cash (in excess of debt)?

Jan 27, 2020

No. Companies essentially bid / pay based on an EV they've determined they are willing to pay, and then back into an equity value to pay shareholders based on that EV.

The companies will just use the target BS to fund the transaction, so that's why we focus on EV. Your equity might be worth more if you have more cash, but I'm going to just use your own cash in order to pay you. That's why bridge loans exist. Banks are willing to lend against the future cash and incremental EBITDA you will receive when acquiring a company.

The reason you do it this way, instead of calculating an equity value is in order to remove the effects of capital structure from clouding your answer.

Jan 27, 2020

You pay equity value not EV.

I can sell you a $1m house that's empty or a $1m house with $100k of cash on the living room table. They both have the same EV. But equity value is $100k more for the house with the cash.

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Jan 27, 2020

You pay equity value not EV.

Your supporting detail is right on, but that means that the buyer pays Enterprise Value and the seller receives Equity Value. I'm not paying $100k more for the house with cash because you're going to take that with you. Similarly, the buyer doesn't pay more or less if there's a mortgage on the house - buyer pays Enterprise Value regardless of the current debt/equity mix.

Purchasers of an enterprise pay Enterprise Value. Sellers of equity receive Equity Value.

Jan 27, 2020

ingles por favor

Most Helpful
Jan 27, 2020

Your logic is not right. Fundamentally, if you have a wallet that is worth $100 and has $10 inside, that wallet is worth $110. If the same wallet has no cash inside, it is worth $100.

Now, most transactions are done on a cash-free debt-free basis. In this case, it means that the seller will keep the $10 in cash. So the buyer would pay you $100 for the wallet (now that you have extracted the $10 and there is no longer any cash inside).

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Jan 27, 2020

Correct. It can be done either way. In reality, more common to just have the seller keep the cash and sell the wallet. But it doesn't matter, the point is that cash can go to value and when it does, its reflected in equity value but not EV. Amazing how another user dragged me down a rabbit hole on such a simple concept.

Jan 27, 2020

Your friend is correct.

Scenario: Cash-free, debt-free transaction (which most private full-sale transactions are, at least if the seller hired a banker). Buyer will pay 5x EBITDA. Seller company (which is 100% owned by one soon-to-be-rich lady) has $10m EBITDA. So the buyer will pay $50m for the company. The company has $10m cash (and $0 debt) on the balance sheet. The buyer and seller agree that $500k of cash has to stay with the company as working capital for the company to function (the actual figure is highly negotiated). The seller receives $59.5m in cash and the buyer acquires the entire company with $500k on the balance sheet, plus "receives" $9.5m.

The main point of the buyer "paying for the cash" is so the seller pays tax on the cash at capital gains (28%), and not ordinary income (50%). If there were no deal, the seller could issue herself a $9.5m dividend, but would pay way more in taxes than if she "grossed up" the purchase price through a cash-free debt-free deal. Also, it is her cash her company earned over the years - she's not just going to give it away for free!

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Jan 27, 2020