THE IMPORTANCE OF REALISTIC VALUATIONS AT THE OUTSET

Private sellers will often not have a good idea about what their businesses are likely to be really worth unless they are being formally advised by experts.

Comparisons with listed companies

For example, a seller familiar with the financial press might have looked at the price earnings ratios quoted for listed firms in his industry and used these to multiply his current earnings to estimate a value. However, a moment’s thought can show that this exercise is unlikely to give a realistic valuation as:

• it’s difficult to find any quoted company that would have exactly the same mix of operations as the business being valued
• a quoted business has access to both capital and liquidity in the financial markets; the small business does not
• investors also have greater liquidity in that they can sell the shares effectively whenever they wish and so are not risking being tied into a specific business long-term
• the increasingly onerous corporate governance rules covering listed businesses in theory provide investors with greater safety.

Each of which means that the value of a listed business cannot readily be equated to that of an unquoted owner managed company.

Potential problems

It will come as no surprise to say that many deals fall apart over price. Three typical problems that you may encounter with sellers are set out below:

I Unrealistic expectations can occur where business owners either have unrealistic expectations as to the multiple of earnings that can be achieved or apply a multiple to an unrealistic level of earnings.

2 Completely unrealistic expectations can occur when a seller does not realise what a buyer will and will not pay for.

For example, some sellers suffer from the condition known as ‘banker’s fallacy’, that because the business has cost me X to set up (even though it is not actually making any money) it must be worth X to somebody else. Of course as a buyer the amount of sunk costs or sweat and tears put in by the seller are completely irrelevant. All you should be interested in is how much money in future profits you are going to get as a return on your investment in buying this business, and whether this return justifies the risk.

3 In some cases sellers have simply not thought through the implications.

You may find that at some point they realise that they ‘cannot afford to sell’, as discussed on page 86.

As a buyer you are therefore probably in the longer run better off if the seller has had some professional advice about valuation early in the process. You will not wish to waste time taking your review of the prospective purchase too far only to find that there is no realistic prospect of the seller agreeing a reasonable price for the business.

HOW DOES PRICE RELATE TO RISK FOR EITHER SIDE?

Most sellers’ objectives in a sale are a mix of:

• maximising the cash received on the sale
• minimising the tax suffered
• a variety of emotional issues such as the security of their employees’ future or the company that they regard as their legacy.

In contrast, the buyer’s priorities are usually:

• to minimise the cash paid out on the sale
• while minimising the risk taken in making a purchase, which usually implies a wish to buy the business and assets rather than the corporate shell.

If the above two paragraphs seem to have made eminent sense, it’s probably worth noting that both the buyer’s and seller’s priorities have been expressed in terms of cash, not price. As will be seen, however, in a business sale terms are clearly as important as price and much of the discussion of terms will focus on the issue of certainty. Remember that:

• the seller is looking for maximum certainty, by way of the cash outcome
• the buyer is looking for maximum certainty, by way of minimisation of the risks being acquired.

The more certain that the seller can make you feel about the business, such as by giving warranties, the more you ought to be comfortable paying them for the business.

And so the buyer and the seller have a mutual interest in establishing as much certainty in the deal as possible – which means as little risk for the purchaser as possible.

VALUATIONS ARE VALUELESS

The fundamental reason for you to buy a business and the one which drives most consideration of valuation is to make money from it.

Business valuation is a mix of art and science and how much you or other prospective buyers will be prepared to pay can depend, not only on the nature and finances of the business to be bought, but also on the nature and finances of the buyers.

You might think for example that all buyers will be taking a fundamentally similar view of the attractiveness of the business and any difference in valuation might therefore simply reflect the differing degrees of confidence that the buyers have in the prospect of the business.

Strategic reasons

This would, however, be to ignore the fact that a particular business may simply be fundamentally more attractive to one buyer than another for strategic reasons. For example, as a buyer looking to purchase a stand-alone business for the first time, you might be in competition with another buyer who is looking to buy the business as a bolt on acquisition to improve their existing business by:

• rapidly entering a new market
• rapidly increasing market share in an existing market
• taking out a competitor
• acquiring a new technology or significant asset.

Any of the above reasons may mean that the other buyer is willing to pay a premium over any normal valuation to acquire this particular business.

In fact in some extreme cases, depending upon their reasons, the amount of money they are prepared to pay for a business bears absolutely no relation to any ‘normal’ valuation of the business. Three examples of real sales illustrate this point.

In some cases commercial logic and questions of return on the investment just go out the window.

The moral of these stories is that different buyers would ascribe different values to a prospective target, depending upon the circumstances and nature of their own business. If you find yourself in competition with a buyer who appears to be willing to pay over the odds for such a reason, do not allow yourself to be forced into overpaying just to beat them. It’s better to let this one go – there will be future targets. You should avoid overpaying on the basis of the value the business could have to somebody else, but where you cannot realise that value. Buy in haste, repent at leisure is sadly as true in the world of corporate finance as elsewhere.

Valuing issues

• As has already been illustrated, putting a value on a private business is a particularly difficult exercise. Whilst a publicly listed company will be valued every day by the stock markets of the world, no actively traded market exists for the particular business that you are interested in until the day it is put up for sale.
• There are, however, a variety of normal financial approaches used to value businesses which will give a range of possible valuations depending on the assumptions used. The detailed bases of these approaches to valuation are given in Chapter 9.

When looking at valuations of target businesses prepared by your advisers, always remember that at best a valuation is an opinion (i.e. a best guess) as to what someone will pay. The only true valuation with any real meaning is the deal that is actually eventually done, when you or someone else puts their hand in their pocket to pay for it, which as shown above may sometimes reflect issues that are completely outside a normal valuation basis.

THE VALUE OF VALUATIONS

Nevertheless you will find that you will need to estimate the value of the target businesses you are looking at, not only for the obvious reason of deciding how much to offer, but also as part of your work in raising finance for the venture and because you must expect that the seller and their advisers will have conducted such an exercise in order to formulate both a target sales price that the seller is looking to achieve, and a drop-dead price below which they will not sell.

Obviously if you can have a realistic view as to these amounts then you will be at an advantage in negotiating price with the seller.

In addition, the process of conducting a valuation may help in:

• identifying assets or parts of the business which you might not want and which you can exclude from the sale to reduce either the risk, or the price, or both
• understanding the price that competing bidders might be prepared to pay for the business
• identifying significant financial risks in the business
• helping formulate your plan for financing the purchase
• acting as an aid for discussion with the seller’s professional advisers.

Valuations should generally all be done on a ‘cash now’ basis, to enable easy comparison from one basis to another. Of course this may not necessarily reflect the actual cash value of the eventual deal, as the payment terms of the actual deal done may differ significantly from an all-cash offer.

Setting a target price

In the same way that a well advised seller will have both a target price and a drop-dead price, so you too should have a target price that you are looking to pay for this business and a walk-away price above which you are not prepared to do the deal.

Once you have achieved your target price this gives you the basis on which to decide whether to continue to negotiate in the hope of striking a deal at a price that is significantly better than your target price, or whether it is better to now move to capture the value you have obtained in achieving your target price by seeking to close the deal. Given the difficulties experienced and effort you have to put in to find the right target, it is in general better to seek to close the deal once you have achieved your target price than to continue to negotiate. Don’t blow a good deal by being too greedy; or blow the goodwill of the seller, which you may need both to close the sale and to make a success of the business once you have bought it, by attempting to screw every last drop out of the price.

WHAT IF THE SELLER HAS SET A HIGH ASKING PRICE?

In some cases you will be dealing with a business that you have approached, which has no published asking price attached to it. In other cases you will be responding to an advert seeking to sell the business which may state a specific asking price.

If there is a published price of the business and it is significantly in excess of your estimate of the business’s valuation, it may be worth asking the seller to explain why such a high price has been put on the business.

You may, however, want to take this as a warning sign that the seller is not serious about selling. There are a surprising number of business owners who take a view that the business is always for sale but only for silly money. You do not want to waste your time dealing with people who are not serious. So if this appears to be the case you should move on to another target.

You shouldn’t forget it altogether, however, as setting a ridiculously high price can be a major mistake for the seller. It may well scare away many potential buyers and send out the message that the seller is not serious.

The effect of this is that the business is likely to remain for sale for quite some time. This will tend to further put off potential buyers as the market will start to consider that there must be something wrong with a business which is not selling.

If and when the seller becomes serious about their need to sell, they will therefore have ‘spoilt their market’ and be unable to get buyers to take them seriously.

It’s probably therefore worth going back to contact highly overpriced businesses, where the number of prospective other buyers is likely to be low, say six months later, to see if the owners are starting to get desperate about selling.

IT’S RUDE TO TALK ABOUT MONEY

As a general rule you should always be looking to open negotiations by asking the seller to tell you how much they want for the business.

For example, you might approach a company that you are interested in buying and ask the owners how much they want. A typical owner-manager’s first response will generally be to speak to their accountant, who as an adviser to a small to medium-size business will not normally be a corporate finance expert or particularly experienced in business sales.

• The accountant is likely to give some very generic advice to the client in terms of a multiple, and on that basis the owner will often start to talk to you on the basis that: ‘My accountant thinks my business is potentially worth £X.’
• The result is that £X becomes the starting point from which you can look to negotiate the price downwards by focusing on both the credibility of the multiple used and the sustainability and quality of the earnings to which it has been applied, hopefully with the result that the business is sold for something significantly less than £X.

In contrast, many professional sellers of businesses such as corporate finance advisers are more likely to take the line: ‘My clients are interested in discussing the sale of their business to you, and would like you to make an offer for it.’

• The result of this approach is that in order to proceed, you will be forced to give an indication of either how much you’re prepared to pay, or the basis on which that sum will be calculated, which may of course be greater than the sum the seller was actually willing to accept.
• As with all negotiations, it is usually best to wait for the other party to mention price first so as to avoid under- or over-offering and to get some indication of their possible range of values.

BASES OF VALUATIONS

There are six broad bases of valuations, many of which are interlinked. These are:

• Asset valuation —the total of the value of all the individual assets, tangible and intangible, in the business.
• Market valuation – a comparison against the prices achieved for other businesses that have sold recently.
• Discounted cashflow – takes estimates of cash to be generated by the business in future years and uses accounting techniques to discount these back to a present value (or an implied internal rate of return that investing in the purchase of the business will generate for the acquirer).
• Return on investment – essentially creates ratios of either the return (the earnings that the purchaser will achieve) divided by the price they pay for the business, or the price/earnings ratio (which is the price they pay for the business divided by the current earnings stream) which shows how long it will take to repay the investment.
• Sector specific – particular sectors will have their own rules of thumb about how to value a business based on the characteristics of the business (e.g. the number of beds in the hotel, pub barrelage, value of mineral reserves, multiples of fee income).
• Basic multiple – as a rule of thumb businesses with certain characteristics will be valued at a certain multiple of earnings.

These valuation terms are explained in more detail in Chapter 9.

WHAT IS FOR SALE?

In order to look sensibly at the valuation, however, you first need to consider the fundamental question: ‘What is actually for sale?’ There are three key considerations that affect this.

What type of sale will it be?

There are two principal methods either by which you can buy an incorporated business (i.e. a limited liability company). These are either to acquire the company by buying its shares, or to buy the business and assets that the company owns from it.

• While this raises a number of issues, for the purpose of considering valuation at this stage, it is enough to note that for tax reasons the owner will generally prefer to sell you shares (i.e. the company).
• However, you will generally wish to buy the business and assets from the company, rather than the company itself, as this allows you to acquire the individual assets at ‘fair value’ for incorporation into your new business’s balance sheet; and also helps to minimise your risk as it reduces the potential for taking on unknown or contingent liabilities as part of the deal.

If you agree to buy the company shares rather than just its business and assets, you are also buying a package of its liabilities. At the same time, the seller is obtaining an important tax advantage. You may therefore wish to seek a corresponding discount on the price you would be prepared to pay to obtain the business and assets without the baggage of the company.

What assets are included?

The second principal consideration affecting value is what actually is for sale. For example, it is not uncommon, particularly in say retirement sales of family owned businesses, for the property from which the business is operated to be retained by the existing owner and to be rented to the new business.

This can be an advantage to the seller as it provides them with an ongoing income, but equally it will obviously reduce the value of the business, as the future earnings will now have to take into account payment of rent.

What liabilities are you buying?

The existing owner/manager may well have had to guarantee some of the company’s borrowings, such as an overdraft, or perhaps leases. When they sell the business to you they will not unnaturally wish to ensure that any such guarantee is lifted, either by clearing the debt to which it relates or by the personal guarantee liability being successfully taken over by the new owners. Therefore the impact of a commitment to repay the overdraft, or settle the outstanding leases, is part of the deal, and will need to be factored into the valuation (and into your estimates of the funds you are likely to be able to raise), together with the impact of meeting over time the company’s normal business obligations such as payment of existing trade creditors.

IS IT REALLY A BUYABLE BUSINESS?

There are many successful businesses providing their owners with a good income but which are fundamentally unsaleable, as the business is essentially inseparable from the person running it.

An example of this might be a consultancy based on an individual’s personal network and reputation as an expert in their field. Such a business probably has no life outside of the individual consultant and their skills and contacts. Therefore there would really be nothing in such a business for you to buy, as on the person’s retirement those people who had come to them because of their contacts, specialised knowledge or reputation, will have no real reason to come to you.

Nevertheless such businesses will often have quite a powerful niche presence or name in their particular industry and so the owners often expect to be able to sell them at a good value.

Transferring knowledge, contacts and reputation

• If you are interested in buying such a business you will in practice have to work closely with the owner for a considerable period either before or after the sale to ‘institutionalise’ their knowledge or contacts into the business so that the business has some life outside of the old owner.
• So, for example, if the business is based around their personal contact network, you need to take steps to formalise this network into some form of database, setting out which customers and contacts provide which sort of lead or service. This would have to be matched with a contact programme whereby the old owner introduces you to their contacts as their heir apparent and, importantly, actively sells the idea to them that in the seller’s absence they should contact you.
• Developing this idea further, the seller may then consider engaging sales staff in order to use this contact database and generate more income independent of the seller’s personal working of the network. From this they can look to develop the business’s brand name such that people who aren’t directly known to them or who come across the business through third parties or through reputation will start to use it.
• Similarly, if the business is built around some specialist knowledge, again in order to have something which is worth buying, this will need to be institutionalised into a database of information, operating systems, processes, or some other mechanisms whereby the value of what the owner knows can be transferred to you.
• In practice the people for whom such businesses have a value are those already in the business and starting to make the contacts or acquire the knowledge as employees or junior partners, who may then buy the owner out over time.

Protecting the company’s knowledge base

Of course, for the existing owner there are significant risks in moving from a one-man band to a business with a structure and a greater number of employees in this way. Not least, where they are attempting to transfer the knowledge or some of the contacts which form the basis of their business into a form that can be transferred to others, there is obviously a risk that departing employees may take some of this knowledge or some of the contacts with them. This obviously also ought to be a concern to you as a buyer, as you do not wish to purchase the business only to find that much of the value can disappear if staff go.

As a result, part of the process of protecting what is being done to make the business transferable is to ensure that all staff have signed proper terms and conditions which include restrictive covenants to prevent them exploiting knowledge if they leave.

Setting up an ‘earn-out’

These sorts of cases are ones where there is no real alternative but to structure the sale by way of an earn-out, where payments to the old owner are dependent upon the profits generated going forwards. This means they have an incentive to work closely with you for the period of the earn out to make the transfer a success.

DEALING WITH A MIXED BAG

What if there are parts of the business to be acquired which you in fact do not want?

You can of course firstly attempt to exclude them from the sale. Depending upon the business’s structure it may or may not be relatively simple to separate out the operations. If, for example, the operations that you do not want are held by a specific subsidiary this could easily in theory be excluded from the sale. I say in theory, however, as in most cases the seller will want to sell the whole business in one transaction and will be very resistant to an attempt to ‘cherry pick’ particular parts, leaving them with remnants that may be difficult to sell.

Of course this is a generalisation and there may be circumstances where an owner is happy to retain particular parts of the business – for example to give them an ongoing income.

If, therefore, you are involved in a situation where part of the price of acquiring the business that you want to buy is that you acquire operations or assets that you do not wish to keep, do not despair.

In fact in some cases the planned disposal of these unwanted elements of the deal can be used to generate significant amounts of cash. Indeed in some exceptional circumstances, disposals of the unwanted elements have been known to almost refund to the buyer the total cost of the acquisition, leaving them with the business they want to buy for a very small net payment.

It is therefore important, as part of your pre-completion planning, and something which can start at the valuation stage, to identify those parts of the business which are to be disposed of, and put in place a plan to realise them effectively for the maximum value as swiftly as possible.

This can, however, present a very real potential dilemma for your post-acquisition planning. To get maximum value from such disposals you need to have your best people working on them. These businesses will require very effective short-term grooming in order to maximise their value, while your managers handle a very compressed sales process, at the same time ensuring that the business to be disposed of continues to operate at the best achievable level.

This is a distraction, since what you really want your best people to be doing is taking over the parts of the business that you want to keep to ensure that these are quickly and successfully integrated into your own operation (which was, after all, surely the purpose of making the acquisition).

An effective way of dealing with this problem is to engage the services of an experienced business seller specifically to manage this part of the project as a self-contained exercise (such as Resolution Inc’s PART service, see page 381), allowing your key managers to focus on the true integration project.