Clients often ask us how debt impacts value. In the immediate term, debt, unfortunately, reduces the proceeds from a sale (equity value), dollar for dollar.
The analogy that we share with clients is that of selling a home. Buyers of homes, like buyers of middle-market aerospace and defense companies, make offers on a debt-free basis. As an example, let’s assume you are selling your home for $1 million. Whether you have no mortgage or a $750,000 mortgage, that has no bearing on the price. While your mortgage obviously has a dramatic impact on your equity in your home, the size of the mortgage has no impact on the price of your home. The exact same is true when it comes to selling your middle-market aerospace and defense company.
When it’s time for you to sell your company, you will see that your potential buyers make their offers just like buyers of houses – they make offers on a debt-free basis. Accordingly, if you receive a $40 million offer and you have $4.2 million in debt, then your cash proceeds from that sale would be $35.8 million.
While debt in the immediate term reduces your equity value dollar for dollar, debt can increase your equity value over time. As we discussed in Deal Note® 41, in 2022, the primary driver of the value of your business is discounted projected cash flow (“DCF”). Accordingly, the equity value of your business will increase if you borrow money and use the proceeds to drive growth in profits, such that the increase in your DCF is greater than the amount of the debt incurred.
Have a great day everyone,
Max McFarland
Associate
