UK: For what it's worth.

UK: For what it's worth. - A combination of high-falutin' theory and down-to-earth horse trading is the most successful way to ensure that those involved in buying or selling a business get the price right.

by Robert Outram.
Last Updated: 31 Aug 2010

A combination of high-falutin' theory and down-to-earth horse trading is the most successful way to ensure that those involved in buying or selling a business get the price right.

A 50% satisfaction rate isn't up to much, is it? Yet, according to one industry observer, at least half of private company sales are regretted by the buyer, with vendors faring little better. Of course, the sale of any business is an inexact science at the best of times but things become far worse when the company in question is private, without a recognised market price for its equity.

Obviously, for a public company it's fairly straight-forward. Arriving at its market capitalisation is a matter of applying arithmetic to the price of its shares. But valuing an unlisted, private company is a trickier process entailing a number of assumptions and comparisons underpinned by some serious number crunching. And while any buyer or seller will find a host of costly merchant bankers, accountants, venture capitalists and the like at their disposal, there are usually compelling reasons why, say, owner-managers contemplating a sale or executives looking at an MBO, might want to get an idea for themselves of the potential value of the business.

There are a number of common valuation methods which are used, often in combination, to arrive at this figure. But whatever the outcome, all are limited by the fact that a company is worth only what the buyer will pay. Thus any seller needs to know his or her buyer to try to glean both how deep is that buyer's pocket and how firm the intention to acquire.

The type and timing of the disposal are likewise crucial. Sellers may wish to remain in charge of the business or wash their hands of it altogether; similarly a cash-strapped vendor may take a discount for a quick sale whereas a more liquid counterpart may hang around sniffing out a better deal. Bearing such caveats in mind, any interested party is likely to use one or more of four approaches: discounted cash-flow (DCF), price/earnings (p/e) analysis, net assets, and a variety of rules of thumb that apply to specific sectors.

DCF has one terrific point in its favour - it is based on cash, the hardest-to-fudge measure of performance. DCF, according to John Allday, head of valuation at Ernst & Young, 'is the purest way. I would prefer to adopt it if the information is there.' Cash-flow analysis (see box) is the classic, textbook approach and it plays a key role in decision-making for many business buyers. Regrettably, though, what looks great on paper rarely translates so well into practice and it is nigh on impossible to apply DCF with any real certainty. The method's Achilles' heel is that it relies on a prediction of future income rather than historical figures, and there is also the drawback that this information will usually (and necessarily) come from the vendor who, to be fair, is hardly a disinterested party.

Because of this difficulty, DCF is seldom used alone - most buyers and sellers will use another method as a 'sense check'.

Much in the way that estate agents sell properties on 'location, location, and location', sellers of businesses tend to tout their wares on earnings.

The favoured method of linking earnings to value is the p/e ratio. For listed companies, p/e is a tried and tested way of evaluating stocks, with the price (ie share price multiplied by the number of shares on issue) expressed as a multiple of earnings. So if, for example, the shares are priced at 25 times earnings, the company is a stock-market darling - those in the know see great things in store for it. Conversely, a multiple of, say, eight shows a stock that most view as something of a turkey.

When valuing a business, Philip Marsden, deputy managing director of corporate finance at 3i, first looks at its track record, its potential and the conditions in its marketplace. To calculate a realistic value, he takes an average of last year's pre-tax profits, the current year, and - if nearing the end of the current year - next year's forecast. These figures must then be adjusted for factors such as non-recurring profits or losses (the cost of launching a new product or selling assets, for example), depreciation policies, and start-up costs. Company owners' so-called lifestyle costs likewise need to be eliminated. These are outgoings such as highly remunerated directors, lavish company cars, and salaries for the MD's spouse. It should be noted that the reverse may also be true: entrepreneurs will often scrimp on their pay packets and eschew pricey perks to help their business grow. Whatever the case, these need to be discounted and replaced by 'reasonable' management costs. As Mary Reilly, a partner at Arthur Andersen, puts it, 'The question is what would be the price of employing management who were not the owners of the business?'

Such calculations completed, Marsden would then deduct a full tax charge of 33% and apply the appropriate p/e ratio, that is, the figure applying to listed companies in the same sector. That figure can be gleaned from the financial pages, but he prefers to use brokers' circulars which give a better idea of forecast p/e multiples. At this juncture says Marsden, 'the science turns into art'. He discounts the price by anything from one-third to a half, not least since private companies normally represent a greater risk than their listed sisters and their financial reporting is seen as less rigorous.

This risk discount is lent weight by the The BDO Stoy Hayward/Acquisitions Monthly Private Company Price Index which shows UK private companies being sold at an average multiple of 10 to 11 during 1996; this compares with multiples of 17 to 18 for the Financial Times Non Financials Index. Of course, this figure can vary widely: on the one hand, excessive dependence on one customer or a lack of experienced 'second-tier' management may drive it down; on the other hand, being in a fashionable growth area such as biotechnology or in a sector with a lot of takeover activity may well cause a business to command a premium.

Discounting is, anyway, ultimately a subjective activity and an exceptional company may merit a much higher multiple if it has a particularly high 'marriage value' to a trade buyer, or if it is large enough to 'match' a smaller listed company. A private company with profits of over £1 million is likely to attract foreign bidders and the resultant competition may well lead to a higher price. The business's management style also makes a significant difference; it may have been run as a 'lifestyle business', to support the owner; or, it may have been run along more aggressively capitalist lines. Notes Allday, 'Generally more security attaches to larger earnings, but the counter-argument is that a small company which is growing like topsy would be valued on a higher multiple'. That said, even the p/e multiples for quoted companies in a given sector may need to be taken with a pinch of salt. As Carl Houghton of accountants Latham Crossley & Davis, warns, 'The p/e you see quoted in the FT is quite often distorted, because share price has already moved on the basis of up-to-date information in the market, but it is being reckoned against last year's results'.

Where p/e calculations are made on the basis of forecasts, it is important that they are credible. Buyers tend to be sceptical when confronted with a plateau of flat historical profits followed by a 'hockey stick' curve representing projected earnings. And, cautions Stephen Baker, head of corporate finance at Grant Thornton, 'A vendor would be well advised not to depend too much on forecasts - they tend to lead to a heavy earn-out element (where part of the sale price is dependent on hitting agreed targets)'.

After cash-flow and earnings, net assets come a pretty poor third in the company valuation game; in fact, when performance is measured as return on capital employed, a company flush with assets can appear flabby. There are exceptions: investment and property companies are judged primarily on their assets; and assets may also have a role to play when the business in question is floundering and the buyer is looking for a comfort factor.

Assets will also have implications if the acquirer is eyeing them with a view to financing future expansion through loan capital. When reckoning a likely sale price, book values should be ignored in favour of professional valuations, especially for items such as properties. Specialist advice is also de rigueur for intangibles such as brands, patents and intellectual property generally; any fees which are incurred on the sale of assets should be deducted from their price.

In addition to the three main valuation approaches there are often sector-specific rules of thumb. Advertising agencies can be valued as a percentage of their annual billings, for instance, fund managers by the volume of funds they control, hotels by their star rating and the number of rooms they operate, and mobile phone companies by the number of subscribers.

But, like any other method, these should not be used alone and, once again, it must be remembered that a sale requires a buyer. As managing director of Jade Securities Michael Shulman explains, 'A private individual cannot say, "My company's valued at x", he can say, "I won't sell it for less than x", and the adviser can say, "Not a problem", "You're off your trolley", or "A bit lofty but we'll do what we can".'

Naturally, the greater the number of potential buyers, the greater the interest they show and the deeper their pockets, the greater the sale price is going to be. And the present clement economic climate makes for something of a seller's market. Once the buyers of last resort, venture capitalists, picking up companies through MBOs have, of late, been outbidding trade buyers,. Same or related-sector companies remain the most likely acquirers, however, since they are usually able to add the most value. One type of buyer does appear to be on the wane: during the '70s and '80s, conglomerates such as Hanson, Tomkins and Williams Holdings were on the prowl for any target which would enhance their earnings, especially their p/e ratios. Nowadays, this approach has fallen out of favour and the market expects acquisitive companies to understand what they are getting into.

But financial engineering isn't dead and a prospective buyer is unlikely to buy a same-sector business that will have an adverse affect on its p/e ratio, so the price remains restricted by the buyer's own profitability.

Douglas Llambias, chief executive of Business Exchange, a network for smaller business sales, is very keen to stress that bidder competition is of paramount importance in valuing a business and that psychological factors shouldn't be overlooked. 'The buyer has to believe that it will be a lost opportunity if he fails to make the acquisition.' Llambias regularly applies this maxim and cites the sale of publishing house Gollancz as an example. Here, the owners who had been offered £1.5 million by US publishers Houghton Mifflin, wanted at least £2.5 million. Within a few months, the spectre of Gollancz being snapped up by another publishing house had convinced Houghton Mifflin to buy it - for over £7 million. The same kind of corporate poker played a hand in the sale of the magazine, International Bulk Transport, which eventually went for a price three times the original offer.

The trap many business owners fall into is that, once approached by a prospective buyer, they negotiate with that firm alone, rather than playing the field. And the nearer the sale is to completion, the more vulnerable the vendor becomes to last-minute pressure. As John Llewellyn-Lloyd, of Close Brothers, points out, 'Once you've gone too far down the line with one buyer, you risk price erosion'.

Even if a mutually acceptable price is agreed, there is still the question of how the purchaser will pay. If the deal involves paper as well as, or even instead of, cash, the vendor must be sure of the value of the purchaser's equity. Initially attractive headline prices may prove less so when the terms, in the form of an earn-out or warranties on the part of the vendor, are onerous. As Reilly puts it, 'The vendor often relies for quite a large part of the consideration on an earn-out. There is nothing wrong with that but it must be tightly controlled by legal agreements you can understand so that terms like "profit" are clearly defined.'

Selling a business can be a fraught process and takes considerable planning if the vendor is to get a good price. Entrepreneurs typically have a lot invested emotionally in their business as well as the financial capital.

The real key to negotiating a price, however, is to be aware of the business's potential value to others. While numbers are important, the price finally agreed will be the result of good old-fashioned horse trading.

DISCOUNTED CASH-FLOW

Too many assumptions weaken a favoured theory valuation theory formula

A valuation based on discounted cash-flow requires credible forecasts of the company's income stream, looking at least three, perhaps even five, years ahead. The DCF formula, familiar to economics and business students, factors in the cost of capital, the preference for cash now rather than in the future, and the element of risk. Expected cash-flow for each year is divided by one plus a fraction which represents the discount rate.

The combined total for the whole period is the net present value (NPV) of the future income.

While the formula itself is theoretically sound, the problem is this: which figures, not to mention assumptions, should go into it? The yearly estimates of cash-flow should be based on a sound business plan and, if it is to be presented to a potential buyer, the forecast should preferably be vouched for by a professional adviser. It helps if the business has reasonably predictable sources of income, such as long-term rental agreements or royalties from intellectual property.

This approach also needs an assumption as to the business's residual value (ie, what it will be worth at the end of the period), either on the understanding that it will be floated after, say, five years, as is normal in venture capital, or that it will continue to be operated as a going concern. The final assumption is the discount which should be applied. This should be based on the weighted average cost of capital (WACC) for likely buyers - not for the business itself. It should also take into account the 'beta factor', that is, the measure of relative risk and volatility for shares in the sector concerned. The more volatile the sector, the greater the discount and so the lower the NPV. John Llewellyn-Lloyd of Close Brothers suggests that around 15% is a good rule of thumb for the typical buyer in today's market.

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