Enterprise value vs equity value: Debt in business valuations

1 May 2024

By: Steven Kay bizval business valuation expert.

What is debt?

The obvious answer is easy: a bank lending money to a company. In practice, this can take many forms, like instalment sales agreements for fixed assets, or term loans that are repaid over several years. It’s rare to find term loans in smaller businesses, as banks are wary of giving money to entrepreneurs without security over specific assets.

There are other types of debt of course, like working capital facilities (or overdrafts). Shareholder loans are common, with debate over whether they should be treated as equity or debt. There can be loans from related companies as well.

When there are third party debts (like banks), it becomes a simple element of the calculation to deduct the debt from the equity value of the business. The situation is murkier for “soft loans” like shareholder loans. We assess each one on a case-by-case basis.

Enterprise value vs equity value

Note the careful use of the term “equity value” rather than “company value” or the more technically correct “enterprise value” – terms used to describe what the assets and operations are worth rather than just the equity.

To explain enterprise value vs equity value. The enterprise value of a business is the value of the assets, less excess cash. There isn’t any science in valuing cash on the balance sheet. After all, a dollar is a dollar! Enterprise value methods focus on the operations of the business, represented by the assets.

Now, the enterprise value belongs to all those who have put funding into the company. This includes debt and equity providers. Debt providers get first bite at the enterprise value cherry, so we subtract debt from enterprise value to arrive at the equity value. This is why the presence of debt leads to a lower equity value that would be the case if there was no debt, all else held equal.

Using the example of a home with a mortgage is helpful, as most people have some experience with this in their personal lives. The value of the home if you put it up for sale is the enterprise value. The bank must be paid off first, which is the debt. The leftover amount is equity which belongs to you as the homeowner. The amount of “equity in the home” is the difference between the value of the home and the balance on the mortgage. Enterprise value vs equity value operates similarly in a business.

So, are companies with debt always less valuable?

No, not necessarily, we need to identify enterprise value vs equity value. Although debt reduces the equity value vs. what would be the case if there was no debt on the balance sheet, the other part of the calculation is the enterprise value. If the enterprise value of company A is much larger than company B, then it’s likely that company A has a higher equity value than company B even if there is significant debt.

Amazon is a perfect example. The group has $64 billion in debt, which is an eye-watering number. Who cares though, when the market cap (the equity value) is almost $2 trillion? In this case, the enterprise value is so huge that the debt almost looks like a drop in the ocean, despite being such a large number when viewed in isolation.

What trends do we see in private companies?

Purely equity funded businesses are generally more valuable than those with smaller amounts of debt. However, once that debt is put to use, the cost of the debt can be outweighed by the increase in equity value. Debt funding is notoriously difficult to raise for younger private companies. With correct structuring and the right business plan, it can lead to a greater enterprise value.

To return to the property example. Think of someone offsetting a bond repayment with rental income to ultimately pay off the property. Rather than stopping once the property is paid off, they reach a point at which they can take out another bond while servicing their existing liabilities. The goal is not to have no debt, but rather to leverage debt into creating equity value. So long as the equity value is increasing ahead of the debt, the value of the enterprise increases. Used correctly, debt is a powerful tool.

Why have so many people and institutions figured out debt financing in property, but not for small businesses? The main reason is that a home loan uses a residential property as security, which is a well-understood asset for banks. Private companies often have no or limited security that is difficult to understand. There’s also the general risk attached to the underlying assets in terms of ability to generate cash flows. After all, everyone needs a place to sleep but few need a boutique bakery.

There is always balance, and that increased risk can lead to a greater reward for both businesses and lenders. Sophisticated lenders also have options like convertible securities, mezzanine funding, etc. that blend debt and equity, but that’s a topic for another day!

Should I take on debt in my business?

It depends on what you want to do with it. Debt isn’t free and we’ve seen many businesses go too far with a risky balance sheet that eventually needs an equity injection to manage the debt. You certainly don’t want to get to the stage that you have to dilute your equity to cover debts. A debt must create additional cash flow, thereby creating equity value and contributing to a greater enterprise value.

The optimal capital structure is found at the balance of debt and equity. If you can finance your entire business with debt, you get to reap the rewards of the equity without having put any money in. But if there’s too much debt, then you can lose all the equity value. If you choose to fund a business via equity, then the risk is lower but the capital requirement for you is much higher, leading to lower return on equity.

Debt and equity both have their place and the optimal capital structure will differ for each business. There is no universal answer. The best option will depend on the specific business, risk tolerance, and a myriad of micro- and macro-economic factors at the time. Over time those requirements may change and the structure will need to be reevaluated. A valuation brings these elements to light, allowing you to make informed decisions about the future of your business and ultimately understanding what your shares are worth.

Without a plan and a solid understanding of what the capital will be used for, raising debt is extremely dangerous.

By: Steven Kay bizval business valuation specialist.