How to calculate total purchase price consideration in an acquisition?
Whether you are the buyer/seller in an M&A transaction, or you’re just the M&A advisor (investment banker, financial due diligence professional, lawyer, etc.), its imperative that you understand the three key elements that go into calculating the total purchase price to finalize the transaction.
As you can see below, the three key elements are enterprise value, debt and cash, and the change in net working capital (NWC). Each of these elements have different characteristics, but they are all related. Below is an illustrative view of how the total purchase price would be calculated:
1) Enterprise value: Enterprise value is typically determined by the buyer based on their method of choice. The most common method is to apply an EBITDA multiple to EBITDA (could be reported EBITDA or adjusted EBITDA), but enterprise value can also be calculated using other methods such as a discounted free cash flow (DFC) or just free cash flow.
2) Debt and cash: Most M&A transactions are debt free and cash free, meaning all reported debt is extinguished by the seller at closing. Additionally, any free cash in the business is retained by the seller and wouldn’t transfer to the buyer. However, there can be other debt-like items in the business that will transfer to the buyer. The buyer would want to identify these items and reduce the purchase price for the liabilities. These debt-like items are typically a negotiation point and would be included in the purchase agreement.
3) Change in NWC: Every business has a certain level of working capital that is needed to operate the business. If there is seasonality in the business, the working capital needed may fluctuate throughout the year. The idea is that the seller needs to provide the buyer with a minimum level of working capital to support the business they are buying (which is based on enterprise value). So if working capital averages $15,000, but the seller delivers $10,000 at transaction close, that means that the buyer has to immediately put $5,000 of cash into the business just to operate the business as normal. To account for that issue, a NWC target of $15,000 would have been set, and if working capital at close was $10,000, then the purchase price would be reduced by $5,000.
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