A car sale and a financial due diligence have more in common than you think
Ever wondered what a car sale and a financial due diligence have in common?
Let’s imagine you want to buy to a car. It’s an average car, which the owner partly financed with a bank loan, there’s a bit of pocket change inside and the fuel tank is typically at 50%.
You agreed to purchase the car at 100.
Let’s look at it from a due diligence perspective. The enterprise value is 100. There’s some debt (bank loan), some cash (pocket change) and you need to account for working capital (fuel tank).
It’s now about determining the equity value starting from the enterprise value. In practice, this is called the “enterprise to equity value bridge”.
So, let’s revise each item individually.
Enterprise to equity value bridge
In most transactions, you pay for the equity value of the company, but oftentimes, the valuation is based on the whole company, i.e. the enterprise value is derived. This is used as a starting point to derive the amount that you are going to pay to the current owner (i.e. the equity value, the price for the shares of the equity).
You agreed that the car is worth 100 (enterprise value) and we’ll assume that this is cash-and-debt free and under normal conditions, i.e. the car must be ready to operate. Therefore, we need to perform some adjustments.
There’s an outstanding debt of 30. The loan isn’t part of the deal and if you purchase the car and the underlying loan you are required to settle it at 30. So, as you need to settle it you want to deduct this from the purchase price. Else, the seller would need to settle the debt before.
There’s pocket change in the car amounting to 10. The current owner will want to take these out before handing over the keys to you. Else, you would need to return the 10 to the buyer.
You’ve agreed to purchase the car under normal conditions, ready to be operated. This calls for a working capital adjustment. You need to determine the reference working capital, i.e. the typical level of working capital. After some thorough analysis, you agreed that a 50% fuel tank level represents the normal level. Let’s assume 50% is worth 25 and the current 10% is therefore worth 5. The seller needs to compensate you for the difference (25–5=20) or recover normal conditions. Let’s assume you’ll have to take care of that.
Equity value — price to be paid
- Starting point: enterprise value = 100
- Deduct the bank loan of 30
- Compensate seller for the pocket change of 10
- Compensate buyer for the lower fuel tank of 20
- Price to be paid: 100–30+10–20 = 60
- The example above shows that the real price can differ from the enterprise value. If there was no loan and the fuel tank would be at 100%, the seller would even have to pay more.
- Another question is how to determine the reference working capital: absolute (liters) or in monetary terms? When determining in monetary terms, price increases are included, which are not included in absolute terms.