You might think you're sitting on a goldmine, but a business is worth nothing if no one wants to buy it. Alan Mitchell explains what can turn a buyer on - or off.
When David Jones put his company up for sale, he didn't realise just how much the yacht his business ran for 'entertaining' purposes would cost him. The final figures made him gulp. Annual operating expenses of £25,000 a year seemed reasonable enough - and taking £25,000 off his firm's profit figure had seemed a better idea than taking it out of his salary.
But when the final price was a 'multiple' of the company's annual profits and this was negotiated as 10 times the figure with the buyer, that meant 10 x £75,000 and a hefty quarter of a million pounds off the sale price.
A trivial example, perhaps, and one that only tells half the story. Even those with no immediate plans to sell up will have wondered in an idle moment how much their business is really worth. To go beyond mere speculation and make a realistic assessment of its value, however, they will need to do more than glance at the latest after-tax profit figure, and assume that someone will stump up a sale price of seven, 10, or even 14 times that number.
Valuations are complex things, affected by many factors. Despite the plethora of well-established business valuation techniques (see box on page 70, the important thing to remember is that the value of a business never stands still. The owner has the means to change it. Real value depends crucially on preparation: how attractive the business can be made to a buyer. 'The formal techniques give you very good guidelines,' says Robert Wallace, a serial entrepreneur who has built up and sold five businesses and is now on to his sixth. 'But whether you can achieve those targets is another matter.'
Barry Alexander, head of corporate finance services at Baker Tilly chartered accountants, agrees. 'It's not a science. Equations can give an intimation of how much a business is worth but they don't tell you the appetite of the potential buyer.' He spends his life selling businesses and says: 'A business is worth what someone will pay for it.' Two years ago, a West Country importer of fashion items wanted to sell his business. Pre-tax profits were an impressive 30% but the business was dependent on one product, susceptible to changes in fashion, and therefore vulnerable. How much was the business worth? Not much - no one wanted to buy it. Since then, the owner has bolted on more products. The business is less profitable in percentage terms but has higher absolute profits. More importantly, its wider product base makes it more appealing to potential buyers, giving it a greater intrinsic value.
A firm's existing accounts are only the first port of call in any valuation and they will almost certainly need adjusting. Yachts or a chauffeured fleet of Rolls-Royces may be attractive perks for family members but certainly not ones a buyer will want to pay for. Quite aside from the effect they will have on annual profits and therefore sale multiples, they are indicative of the very personal way in which the business will have been managed.
'Add back all proprietorial costs of whatever nature, and leave the purchaser to include a cost for replacement management,' advises David Brooks, a partner at accountancy firm Grant Thornton. Unwanted assets can be turned into cash, and cutting back on long-term R&D and other investments can also boost current earnings figures.
However idle the valuation, it is important to view the business dispassionately, as if from a potential buyer's point of view. At a superficial level, messy, dingy factories and offices with peeling paint send negative messages to potential buyers. They smack of neglect, a lack of investment and poor management. Sprucing up the physical look of the business could make a difference (but would obviously have to be costed in). 'In some ways, selling a business is like selling a second-hand car,' says Stephen Baker, head of corporate finance at Grant Thornton. 'Would you leave it in the driveway covered in mud with crisps on the seats, or without a service record?'
Owners should imagine themselves at 'due diligence' (the stage at which professional advisers go through the company's paperwork with a fine-toothed comb). The tying up of loose ends at the end of hard negotiations is often seen as a technical matter, but the reality is very different.
Due diligence is when the buyer really tests the business. It can be the kiss of death to a deal. Nick Martin, who has been through the process many times, is a director of the private equity division of Mercury Asset Management (MAM) and a professional buyer of companies. He says it usually goes one of two ways: 'It's either a virtuous circle of increasing confidence and enthusiasm, or a negative spiral of ebbing enthusiasm and lost confidence.' In other words, this is when an over-hopeful valuation will collapse under intense, critical scrutiny - and the tough talking really begins.
There are certain classic areas where businesses often fall down. So even owners making a speculative valuation should take a cool, hard look at their financial controls, their information systems, supply chains, customers and intellectual property. Baker Tilly's Alexander came across a wine importer a few years ago which on the face of it made decent profits but had accounting systems 'so disastrous, they would never have got past due diligence'. A team was brought in to introduce a new accounting system which, as far as Alexander is aware, is still there. 'If a company has a nugget buried in there, you can sometimes persuade a buyer to ferret it out. But, in this case, it was too extreme and would have taken any buyer too much time,' he says.
Too often, financial controls and information systems are simply 'not up to the job', says Derek Lewis, a former chairman of the television company UK Gold and now a non-executive chairman of several businesses in which MAM invests. At the worst extremes, bosses may not even know what their most profitable product lines are. Combined with other weaknesses, such as 'amateurish marketing' and 'short-cut manufacturing routes', this can have an adverse effect on value, Lewis adds.
Supply chains, customer base and intellectual property are other Achilles heels. As the West Country fashion importer discovered, being over-dependent on one product can override everything. Similarly, an overreliance on one or two customers can deflate the value of an apparently healthy business.
Grant Thornton's Baker recalls one instance where a business was sold at a good price, despite more than 50% of its revenues being tied up in one contract. Within 18 months, the contract was not renewed and the new owners found the rug had been pulled from under their feet.
Even close personal relations with particular customers count for nothing if the customer is loyal to the owner and not the business. Export sales may be equally vulnerable if they are dependent on a network of commission-driven overseas agents. What happens if the agents suddenly drop the company's product line in favour of a more lucrative offer? Long-term, formalised agreements achieve a measure of security and intellectual property should certainly be protected by formalised legal ownership or a major asset could be ripped off, leaving the company with little comeback.
Many bosses assume the workforce is the 'best asset' the businesses has, says Baker. It may be, but proprietors must ask themselves what exactly is the nature of that asset. If a potential buyer intends to relocate production, the workforce soon becomes little more than an expensive liability.
Equally, the knowledge and experience of a long-serving workforce can be invaluable but, if 'Bill' is always on hand to sort out a particular key problem, what happens if Bill walks out of the door and never comes back? A company's value is likely to be enhanced if knowledge of how the business works and of the needs of key customers has been embedded in formalised systems and processes. Put brutally, a happy but informally run business won't fetch as high a price as a methodical machine. Proprietors often have a blind spot, says Baker. They shouldn't take anything for granted.
Value is in the eye of the beholder. Alexander was involved in the sale of a Midlands engineering group a few years ago. It had four divisions, which sold heavy equipment, reconditioned equipment, manufactured widgets, and also owned property. The widgets lost money but the remaining businesses were attractive, albeit not to the same buyer. In the end, the new equipment division was sold to a Southeast Asian buyer, while the reconditioned business became a bolt-on to a British company. The proprietors continued to own the freehold properties, generating a regular leasehold income stream.
Even an apparently crippling weakness may enhance the business' value to the right buyer. A small, fast-growing firm with an excellent new product may bemoan its lack of an international distribution network. Yet, a buyer with such a network already in situ could maximise the potential of the new product without the hassle or cost of dismantling a distribution system it doesn't need. The proprietor of a road haulage firm - a highly competitive market with minimal barriers to entry - may naturally focus on the business' difficulty filling trucks. However, if he owns the freehold to his muddy, oily, but ideally located premises, a potential purchaser might be extremely keen to buy. Filling trucks becomes irrelevant.
'The thing to do is to target buyers that might see synergies in the business,' says Alexander. He has just been involved in selling one of the UK's top six cleaning companies. 'We went to all the standard buyers for the A list. Our B list was companies that buy cleaning services, who would see cleaning as a profit centre.' It paid to look through different eyes. A company on the B list was happy to pay considerably more than a standard buyer might have paid.
Another trick is to target the venture capitalists' coffers, particularly recently raised funds, where the venture capitalist is itching to get the money out. 'There is too much money chasing too few deals, now and for the next few years,' says Alexander. 'Marginal deals are fetching reasonable prices but, if a company is first rate and on the market, extraordinarily high values are being paid purely on the basis of supply and demand.'
Sorting out key issues such as customer and supplier stability, cost structures and accounts, management succession and skeletons in the cupboard are all essential in order to maximise a company's valuation. Nasty surprises can be deal killers. If they keep turning up, an enthusiastic buyer will get cold feet and walk away. If the deal does go ahead, it may be at a much lower price. 'Weakened confidence knocks points off the multiple,' says Baker. Buyers expect and always look for skeletons in the cupboard.
These could include pending litigation or environmental clean-up costs - in any valuation, hypothetical or real, the proprietor should factor these in. 'Every business has skeletons,' says Martin of MAM. Keeping them hidden is inadvisable, not least because they are never as bad as they seem to the vendor and can usually be tidied up.
So, clearly the value of a business depends on many things. A business with a world-beating product that can't expand fast enough is a very different proposition to one that has lost its way. It depends on who's buying - one buyer's meat is another buyer's poison. If a sale is on the cards, it depends on whether or not the entrepreneur appoints expert advisers to help with the most appropriate valuation method, the best exit route or tax planning. Identifying the right sorts of buyer is essential and it is important to find an adviser who will go out and find them.
As with everything, preparation helps. Using formal valuation techniques is a useful ballpark and a business that is sound should attract a higher-than-average multiple. On a business with £500,000-a-year profits, increasing the multiple from seven to 10 will add another £1.5 million to the sale price. A poorly run, ill-prepared business, however, could see the multiple sliding the other way - from 10, to seven or below. As Grant Thornton's Baker points out: 'Owners tend to be buried in the day-to-day running of the business and they don't often focus on selling the company until they decide they want to do it.' By then, it could be too late. The owner may want to sell in the next six or nine months but that is as long as it often takes to complete the actual sale.
Even when a would-be buyer appears like a bolt from the blue, if the business is unprepared, the value may suffer. 'The buyer comes along,' says Peter Hemington, partner in charge of the vendor industry unit at BDO Stoy Hayward, 'and says: "We think your business is worth between £7 million and £10 million." The vendor immedi-ately sees the £10 million - but the purchaser is really thinking £5 million,' adds Hemington. 'The offer is finally agreed at £7 million before being driven down as the due diligence process unfolds.' Vendors blinded by this process are often prepared to accept surprisingly large price reductions as the inevitable problems raised are dragged into negotiations. So it is as well to think about how much your business is worth - and to whom - before the yachts, Rolls-Royces or an ecological disaster waiting to happen start nibbling away at the foundations.
TRIED AND TESTED
There are a number of different valuation techniques, including tried-and-tested, rule-of-thumb methods specific to particular sectors such as hotels or publishing.
- The earnings multiple: this is the most common method in the UK. After-tax profits (or the earnings figure) are calculated and multiplied by an industry average. The earnings figure must represent a realistic assessment of the business' profits, after stripping out factors such as over-generous proprietorial emoluments or creative accounting. Essentially, it tells a buyer what its potential future income stream could be. The less risky this looks, the higher a multiple the buyer will be prepared to pay. The average multiple in larger private sales has hovered between 10 and 12 over the past few years, though this may go down in times of recession. Generally, the multiples achieved by private companies are around 30-40% below those of listed companies in the same sector.
Different industry sectors tend to achieve different multiples, and averages within these sectors can be misleading. The best companies in the same sector can achieve multiples up to three times greater than the worst. In the end, it's the quality of the business that matters.
- Discounted cash-flow methods: these look at the ability of the business to earn cash over a specified period in the future. After adjustments for items such as depreciation and capital expenditure, the value of those future cash-flows is adjusted for future inflation over that period, and the 'discounted' cash values are added up to create a current price.
- EBITDA: this takes a similar approach to discounted cash-flow methods and is becoming increasingly common in the UK. EBITDA stands for earnings before interest, tax, depreciation (of tangible assets such as plant and machinery) and amortisation (the depreciation of intangible assets such as goodwill or patents).
- The net asset method: this looks at how much could be raised by selling the assets of the business, with a premium for goodwill thrown in. It may be appropriate for a business whose asset value (in the form of property, plant and equipment or formal intellectual property) is high. It may not do justice to businesses that buy in office equipment on hire purchase or rent it and whose real asset is the people they employ.