Comparing enterprise value and equity value in an SMB

Enterprise value is the total value of a business to all stakeholders including debt and equity holders. 

The formula for enterprise value can be expressed as equity value + debt - cash.

The reason why cash is subtracted to get enterprise value is because cash would be used to pay down debt in the event of a sale. By subtracting cash and cash equivalents, you are focusing on the core operating value of the company. 

Equity value is how much the owner's stake in the business is worth. This represents the actual amount the sellers will receive for the company if they sold their shares and can be calculated using the following formula: enterprise value + cash - debt

Equity value will always be less than or equal to the enterprise value. If a business is worth $1M with $700,000 of debt, the equity value is $300,000. The book value of a firm’s equity is called shareholder’s equity. The market value of a firm’s equity if publicly traded is called the market capitalization. This is helpful for conducting relative valuation as you can find comparable companies with similar market capitalizations. 

But, can equity value be negative?

Actually, yes! Equity value can be negative if a business has a lot of debt. We’ve seen this a number of times with small businesses who have minimal earnings and lots of outstanding debt.

However, the market capitalization of a firm can never be negative as you cannot have a negative share price or shares outstanding. 

When to Use an SMB's Enterprise Value vs. Equity Value

Most small business owners prefer stock sales (although asset sales are more common). Why? In a stock sale, sellers are generally relieved of direct responsibility for the entity’s liabilities. Additionally, C-Corp and S-Corp shareholders will be taxed at preferential capital gains tax rates.

In the context of a stock sale, equity value is the important metric to use because it represents the value of the ownership stake in a company's common equity being bought and sold.

For an asset sale, one would look at enterprise value to evaluate how much a business is worth. The parties may use it to determine the total price for the asset purchase.

When a business is bought on a cash-free, debt-free basis it means that the seller is expected to pay off all of the company’s debts and extract all of the company’s cash prior to completion. 

During the transaction, normally the buyer will “pay” for the business using a mix of debt and equity. So, after the close of the business, although the enterprise value may be the same, the exact equity value may be lower because the buyer layered on an SBA loan that's larger than the company's previous outstanding debt under the old ownership.

Note: Most deals are structured as asset sales as the buyers do not want to assume the outstanding debt of the seller or the legal and tax liabilities of a multi-generational business.

Sample of SMB Enterprise Value and Equity Value over Time

The below model shows how an SBA-financed acquisition may look over the first 5 years.

As you can see in the model, the business starts with a total enterprise value of $1M and an equity value of $100K. There is a lot of debt on the business between the outstanding bank loan and an almost equivalent seller note.

As the years go buy, the business may pay down the debt with cash from the business and, thus, the equity value increases.

This example shows the enterprise value remaining constant at around $1M.

Generally, the enterprise value increases when the business grows or there is multiple expansion (e.g., improved operations and / or better market conditions giving you a higher multiple).

What Happens to Equity Value in a Dividend Recapitalization of a Small Business?

In a dividend recapitalization, the company borrows money, usually by taking on additional debt, and then uses the borrowed funds to pay a special dividend to its shareholders.

While the special dividend provides a cash payout to the shareholders, it doesn't change their ownership stakes in the company. Shareholders retain the same percentage of ownership they held before the dividend recapitalization. However, the small business is now responsible for repaying the new debt, including both principal and interest, over a specified period. This debt decreases the value of the equity, even though it doesn’t dilute the ownership percentage.

A business could pursue a dividend recapitalization for the following reasons: 

• Liquidity for Owners: Owners of small businesses often have a significant portion of their wealth tied up in the company. A dividend recap allows them to extract some of that wealth in the form of cash while retaining ownership.

• Reinvestment Opportunities: Shareholders may use the cash received in a dividend recapitalization for other investments or business opportunities.

• Tax Efficiency: In some cases, the tax treatment of dividends may be more favorable than other forms of income, such as interest or capital gains, leading to tax planning benefits.

• Shareholder Expectations: Shareholders may have expectations of receiving periodic returns on their investments, and a dividend recap can be a way to meet those expectations.

The Effect of Leverage on SMBs

Additional debt allows businesses to reinvest capital for higher returns. Debt can provide a source of capital that allows a small business to pursue growth opportunities, such as expanding operations, launching new products or services, or entering new markets. Debt can also be a suitable option for meeting short-term working capital needs, covering seasonal fluctuations, or addressing temporary cash flow challenges. 

By using debt to finance growth or meet financial obligations, small business owners can avoid diluting their equity ownership. This means they retain a larger share of the company's ownership and potential future profits, in exchange for decreasing the value of their equity through more debt.

All of these benefits are only applicable if a business is stable since high interest and principal payments can cripple a firm with volatile cash flows. 

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.