Enterprise Value (EV) in the Mid-Market

Source: www.capital.com/ev-sales-definition

Source: www.capital.com/ev-sales-definition


Back to the basics of any company valuation, whether public or private, large-cap or middle market, Enterprise Value (EV) is an indispensable part of the pieces named.

This article discusses the major tenets of what is EV, how it applies to private companies in the middle market, and how financial analysts use it to value, well, enterprises.

Ok, let's begin exploring the EV and its areas.

What is EV?

Enterprise value, whether being discussed for private companies in the middle market or larger publicly traded companies, essentially yields the same definition.

Generally, EV is defined by the following formula:

EV = Market Capitalization + Net Debt (Total Debt - Cash and Cash Equivalents)

Let's provide some color on each in turn.

*EV also includes aspects touching upon: 1) Minority Interest, 2) Preferred Stock, and 3) Other Adjustments (such as for pension liabilities, operating leases and similar items). But for the purposes of this article, we'll just focus on the two aforementioned components of the equation.

1. Market Capitalization

In this section, the terms valuation of private middle market companies and market capitalization of the former will be used interchangeably.

For publicly traded companies, Market Capitalization, or Market Cap, is the sum of all shares outstanding x share price. Or in other words, how the market values an enterprise on the stock exchange. It emphasizes equity on the balance sheet (BS) background.

On the other hand, middle market private companies do not have publicly traded share price, hence their market cap can't be directly derived. That's why investment bankers turn to tools of valuation such as a) financial fundamentals, b) transaction comparables, or c) information disclosed during funding rounds regarding the potential valuation of the company.

a) Financial fundamentalsare usually core financial metrics and performance indicators used to assess the company's health, profitability, efficiency and growth prospects.

It's effectively and umbrella term encompassing revenue and profitability, cash flow, balance sheet analysis, and the like. Since market value can't be derived from a publicly traded price, these metrics are key to understanding and determining the private company's market cap.

b) Transaction comparables, or usually called "comps," are another tool which can also be used in determining private company's valuation. It involves analysis of financial metrics and the sale prices of similar companies in the same industry/ sector that been recently sold or acquired.

c) Finally, disclosure of valuation figures based on investments received during funding rounds; it's important to say need not be exclusively the "startup domain." Although associated very often with startups and early-stage companies, established private companies engage in funding rounds too. These companies use funds attracted from investors for strategic capital restructuring, expanding or developing a new product.

Now that we've covered the valuation/ market cap part of the equation, let's move to Total Debt.

2. Net Debt

Sometimes referred to as a Net Debt in the EV formula, sometimes broken down into its two subcomponents: Total Debt, and Cash and Cash Equivalents, we will start with Total Debt and how it fits into the story.

Net Debt = Total Debt - Cash and Cash Equivalents

2.1) Total Debt

Total debt includes all of the company's obligations that are classified as debt, which can consist of; short-term borrowings (like lines of credit and due portions of long-term debt within the next year) and long-term debt (such as bank loans, bonds, and other financial instruments with maturities beyond one year).

2.2) Cash and Cash Equivalents

These of course are the most liquid assets on the company's BS, including items such as; currency on hand, demand deposits with banks, and short-term investments that are readily convertible to known amounts of cash with original maturities of three months or less.

2.3) Net Debt: Revisited

How total debt and cash tie in together?

If total debt > cash available, this can mean the company is investing a lot in its operative, financing and investing activities but might be overleveraged due to high debt levels. So, the EV can be higher but the company might be experiencing solvency issues.

If total debt < cash available, this can mean two things: the company is very liquid and can pay off all its debt, hence it has a positive net debt figure. On the other hand, if there is a really high amount of cash not utilized, it might depict company's inefficiencies in business model/ day-to-day investing/ financing/ operations.

Enterprise Value - High and Low Scenario

EV and valuation are used interchangeably here, for private middle market companies. There are nuances in determining factors between a high and a low enterprise value, and how they affect stakeholders. Here's what can be inferred from high and low EV valuations.

1. High Enterprise Value

a) Investor Interest - A high EV often attracts more interest from investors and private equity firms, as it suggests strong underlying business fundamentals or significant growth potential. Investors may see the company as a valuable opportunity to achieve substantial returns.

b) Funding Opportunities - Companies with high EVs may find it easier to secure additional funding. Investors are typically more willing to provide capital to businesses they perceive as successful and stable, which can facilitate further growth and expansion.

c) Acquisition Premium - If a private middle-market company with a high EV is considering a sale, it may command a higher premium in the market. Acquirers might be willing to pay more for a company that demonstrates strong value and potential.

d) Market Positioning - A high EV can enhance a company's reputation in its industry and among its peers, potentially leading to beneficial partnerships, customer relationships, and expansion opportunities.

2. Low Enterprise Value

a) Acquisition Risk - Private middle-market companies with low EVs might be seen as targets for acquisition at much smaller price, particularly if potential acquirers believe they can turn the business around or integrate it for strategic value.

b) Challenges in Raising Capital - A lower EV can make it more challenging for a company to raise funds. Equity financing may lead to significant dilution for existing owners, while debt financing could come with unfavorable terms.

c) Strategic Reevaluation - A persistently low EV might necessitate a thorough strategic review to identify and address underlying issues. This could involve reassessing the company's business model, market positioning, cost structure, and growth strategies, among others.

d) Owner and Stakeholder Concerns - For business owners and stakeholders, a low EV may raise concerns regarding the company's financial health and future prospects. It might lead to increased scrutiny/ review from lenders, suppliers, and potential partners.

Final Thoughts

Effectively, although EV is more used in publicly-traded companies discussions, it still provides a good framework, and a useful benchmark for owners and investment bankers alike to value the respective company and make decisions/ advise accordingly.

Redmount M&A is a strategic partner for aiding companies in the whole dealmaking timeline and deal construction: from the beginning until the end of the transaction. Due diligence is a demonstrated track record of the firm's operations and a trusted confidential part of the process. Finally, Redmount helps companies in the middle-market space to execute transactions, achieve strategic capital restructuring, and in effect, increase the desired long-term market expansion objectives.

Senior Investment Banking Associate at Redmount M&A and Associate Deputy of Chairman of the Advisory Board at Dimension Investments