Help! My Business is Overleveraged… Is It Really Worth Nothing?
One of the more daunting scenarios a business owner faces is when their company’s debt exceeds its enterprise value. But does this mean the business is truly worth nothing, especially when it can still generate positive cash flow and meet lender covenants?
For a brief business valuation crash course, enterprise value refers to the operating value of a company. In most cases, it’s determined using both the market and income approaches; the market approach relying on multiples of comparable companies or transactions, and the income approach focusing on the present value of unlevered forecast cash flows. A company is considered “underwater” when its net debt surpasses its enterprise value. This can occur due to overleveraging or significant downturns in business performance, resulting in declining forecast cash flows.
To address this issue from a valuation perspective, an option pricing model (OPM) can be employed to value the company’s equity. The OPM treats debt and equity as call options on the company’s enterprise value, typically using the Black-Scholes formula. Below is a breakdown of the Black-Scholes formula and the key assumptions a valuation appraiser must consider in determining equity value:
- Starting Equity Value (S): Current enterprise value, determined using the market and income approaches
- Strike Price (K): The enterprise value required to cover debt obligations, including interest
- Time to Maturity (T): Either (A) the weighted average duration of all debt claims, (B) maturity of senior debt, (C) maturity of the longest-term debt
- Risk-Free Rate (r): The government bond that aligns with the time to maturity
- Volatility (𝜎): The annualized standard deviation of stock returns from a selected peer group of publicly traded companies
Using an OPM, a business appraiser can often determine a positive equity value, even when the company is technically underwater. However, relying on this model for a company that repeatedly finds itself in such a position could raise concerns about its long-term viability, potentially signaling the risk of bankruptcy. That said, in answer to the original question, a business can still hold positive value despite significant debt obligations.
For more information on this topic, I will be speaking at The ESOP Association – California/Nevada Annual Conference on September 26, 2024.
