This Bridge Helps Understand the Big Picture in Financial Due Diligence
Thoughts on How the Results of a Due Diligence Impact Purchase Price Considerations
Why do we perform these analyses? What’s the purpose behind all this?
I started working a couple of years ago. In the beginning, I found myself stuck between technical analysis and general understanding. I got caught in the details and by everything around me.
So, I often asked myself what the purpose and the contribution of the due diligence work were.
In most transactions, to identify the purchase price, a “waterfall” is applied. The waterfall looks the following:
./. Net financial debt and debt-like items
+/- Working capital adjustment
+/- Deferred capex
= Purchase price / Equity value
This structure is often applied in the purchase price contracts to determine which price the investor needs to pay. The input for this is based on the financial due diligence.
In this article, I’ll cover how the results of a due diligence help determine a purchase price in an M&A transaction.
First, you need to determine the enterprise value. The enterprise value reflects the findings from the due diligence. This includes for example the adjustments to the data provided by the target. The adjustments are identified based on a thorough P&L analysis covering expense items, revenues, and an assessment of the business plan. Based on this, the potential investor determines or negotiates an enterprise value, e.g. with multiples or DCF. Then, to determine the equity value, you need to deduct debt. Debt and debt-like items are identified within a detailed balance sheet analysis.
Balance sheet analysis
The balance sheet covers more than determining debt and debt-like items. It covers at least two more questions. First, what’s the reference working capital, and second, is there any capex backlog? Insights on the reference working capital support the working capital adjustment. This adjustment considers whether the working capital at closing reflects the typical level or if it’s too high or too low. In case it is too high, i.e. the seller has already bought more working capital than required, the buyer compensates the seller with an extra payment. In case it is too low, the buyer has to purchase additional working capital. This leads to a reduction in the purchase price. The capex backlog might lead to a further purchase price reduction. This is due to an injection of money that should have been invested earlier.
In short, these aspects describe the path from enterprise to equity value. The enterprise value is determined via the analysis of the income statement. The equity value is then determined with insights from the balance sheet analysis. Working capital, net debt, and potential capex adjustments form the bridge from the enterprise to equity value.
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