Minority investment valuation: EV or Equity Value?
July 29, 2024
by a searcher in Montreal, QC, Canada
I was reviewing a deal for a minority investment in a private business and the owner is using the Enterprise Value (EV) as the basis to buy into the company.
Would it be more accurate to use the Equity Value (EV - net debt) to determine the valuation of the shares?
Example, two different scenarios (without the impact of share issuance):
1. $10m EV. If I invest $1m I would own 10% of the equity
2. $10m EV, $5M net debt = $5m equity value. If I invest $1M, I would own 20% of the equity.
Big difference.
What approach makes more sense and why?
in Montreal, QC, Canada
Thanks all for your answers. Wanted to share an update on this.
1. When I say equity value, I don't mean Book Value of the equity. Equity Value will be derived from valuing the business, finding it's EV (i.e., $1M EBITDA x 5.0x = $5M in EV), and from there, removing the net debt. This means that the equity value reflects the "market" value of equity .and not the "book value" of equity.
2. Let's take an extreme scenario: if we decide to sell the business 1 week after doing our minority investment.
Scenario 1: assuming we buy in at the EV a business that has $10M of debt
- Imagine a business with $20M in enterprise value, and 1,000 shares (at EV, this is $20K per share)
- If I make a $500K investment, the business would issue 25 new shares, so total share count would be 1,025
- Our ownership would be 2.44% of total shares outstanding
- If we SELL THE BUSINESS 1 WEEK LATER at the same valuation, what happens:
- $20M goes to the seller, $10M is used to repay the debt, and $10M is left for the equity holders
- If I own 2.44% of that, I would get back $244K from my $500K investment - big loss
Scenario 2: assuming we buy in at equity value in the same business
- $20M - $10M = $10M of equity value
- with 1,000 shares it means $10K per share
- Our $500K investment gets us 50 shares, so new shares outstanding is 1,050
- After dilution we end up owning 4.76% of the total shares
- If we SELL THE BUSINESS 1 WEEK LATER at the same valuation, what happens:
- $20M goes to the seller, $10M is used to repay the debt, and $10M is left for the equity holders
- If I own 4.76%, I'm getting back $476K
Does it make sense to invest based on EV instead of the market value of equity?
from Harvard University in Lynbrook, NY 11563, USA
Personally I think it makes a big difference if the debt is personally guaranteed by the owner. If yes, he has a good argument that he bears far more of the risk of leverage and should get more of the benefit (but not all of it!). If no, then all equity bears the risk equally and so I would argue for getting at least closer to enterprise value.
Economically, if you wanted to be technical, you might ask what debt could this business get (amount and interest rate) without a PG v. what it can get with a PG. Then you'd figure out what value gets you the benefit of debt absent a PG, and allow the owner to get most of the rest of the PG benefit (I say "most" because the additional debt from the PG still creates more risk for you, so I haven't given you a technically perfect way of calculating this).
The "step up" concept for preferred investors is intended to address this issue, and how much of a step up you get (1.5x, 2x etc.) determines where you land on the equity-enterprise value scale. A 1.5x or 2x step up is very common in ETA deals, but the particulars of your deal should ultimately govern.