M&A and Valuation terminology
Understanding mergers and acquisitions (M&A) and valuation terms is essential for anyone involved in corporate finance. This article offers a straightforward list of key M&A and valuation terms along with their definitions, providing a handy reference to help you navigate these concepts with ease.
Agreement terms and conditions
When selling a company, a seller provides warranties in the form of terms and conditions. These warranties are an important part of the purchase agreement. They basically are statements regarding the state of the company that is being sold, confirming that ‘everything is as expected’. These conditions should be free from any known risk at the moment the contract is signed. The usual fiscal warranty term is 5 years.
Cash and debt free
This term is often used during transactions. It equals the price for a company without any debt or cash on the balance sheet. Debts are paid off before the transaction date and all cash will be distributed to the shareholders. The buyer will have to provide the company with his own (working) capital.
DCF: Discounted Cash Flow method
The Discounted Cash Flow method is based on the free cash flows a company is expected to generate in the future. These cash flows consist of cash that is available on an annual basis in order to pay interest, pay off debt or to pay dividends to shareholders. The sum of profit before interest an after tax, plus depreciation, minus net investments in working capital and fixed assets, plus/minus non-cash elements. In case of DCF method, profits do not affect the valuation. Cash flows that are discounted against a certain required rate of return are the basis of the valuation, no matter what profits are. This required rate of return is determined by the buyer at the moment he intends to buy the company. The higher the risk profile of the company, the higher the required rate of return will be, and therefore the lower its value. Note: risk profiles will vary from one company to the next. For example, income generated by the long-term rental of a building has a lower risk profile than income generated by a property developer constructing buildings.
Due Diligence (DD)
Generally, a buyer of a company will require an audit (at his costs), regarding the financial, legal and fiscal aspects of the transaction. This is called a due diligence (DD). Depending on the agreements between seller and buyer, the nature of the DD can vary.
Clear formulations of the DD, the effects of the results on the transaction price and conditions are key factors for the success of a transaction. If the information assessed during a DD differs from the information provided earlier, it may give the buyer cause to question the conditions agreed upon.
Discounting cash flows
General: Discounting cash flows is a method to calculate today’s (or an desired moment in the past) value of future cash flows. Specifically for valuation purposes, it is a method to discount annual cash flows using the cost of capital at the moment of valuation. The following formula explains:
PV = Present Value, Discounted Value
n = Year
FCF = Free Cash Flow
K = Cost of capital
DSCR: Debt Service Capacity Ratio
EBITDA -/- Investments in fixed assets -/- corporation tax
Repayments + interest paid
EBIT: Earnings Before Interest and Taxes
Earnings before interest and taxes (EBIT), is a measure of a firm’s profit that includes all expenses except interest and income tax expenses. It is the difference between operating revenues and operating expenses. In other words: the net profit plus interest plus taxes.
EBITA: Earnings Before Interest, Taxes, Depreciation and Amortization
Net profit plus interest plus taxes plus depreciation plus amortization. EBITDA is often regarded as an important indication of the operational performance of a company because it eliminates the effects of financing and accounting decisions.
Enterprise value
The enterprise value is the total value of a company, without taking into account how the company is financed.
Free Cash Flow
Free Cash Flow represents the actual amount of money that can be paid to equity investors or loan capital providers on an annual basis without putting the continuity of the business at risk. The free cash flow is calculated as follows:
EBIT (Earning Before Interest an Tax) -/- Taxes on EBIT
= NOPLAT (Net Operating Profit Less Adjusted Taxes)
+/+ Depreciation
-/- Investments in assets
+/- Change in net working capital
+/- Change in amenities
= Free Cash Flow
ICR: Interest Coverage Ratio
ICR indicates the company’s income in terms of interest costs. This ICR benchmarks the extent to which the profit before interest and tax may drop without endangering the company’s financial position. It is also an indicator of the amount of loans, including interest costs, a company may be able to apply for in the future.
Operational result before interest and taxes (EBIT)
Gross interest paid
Indemnities
During transactions, indemnities are provided by the seller of a company. As opposed to warranties, indemnities concern specific matters that involve risks. These risks are apparent at the moment the purchase agreement is signed, but the scope of these risks is not yet clear at the moment of signing.
LOI: Letter of Intent
A Letter of Intent is drawn up by the seller and buyer when they have agreed upon a price, the outlines of their agreement, and the conditions. These conditions generally include the successful arrangement of financing and the positive results of a Due Diligence.
NDA: Non-Disclosure Agreement
A document to be signed by interested parties before they will receive extensive information (including the name) about a company regarding a transaction.
Value based management
Value based management is a management technique based on strengthening the key value drivers of a company, aiming to increase the company’s value.
M&A: Mergers & Acquisition
This pertains to the processes of mergers and acquisitions where companies combine or one company purchases another company.
SPA: Sale and Purchase Agreement
This is the agreement in which the terms of the acquisition are established.
Earn-out
Part of the purchase price that is contingent upon meeting future performance criteria.
PE: Private equity
Investments in non-publicly traded companies by private investment funds.
IM: Informatiememorandum
A document that contains detailed information about a company that is being offered for sale.
M&A Specialist with extensive Experience
As Aeternus, we have been closely involved in hundreds of acquisition processes over the past eighteen years. We understand the questions and uncertainties entrepreneurs face during this process. If you would like a consultation about your options, contact us for an appointment with no obligation.
