GROOMING FOR SALE

Grooming is the term for the process of preparing a business for sale and making it as attractive as possible to prospective purchasers. To properly groom a business for sale may take two or three years, although if you haven’t got that long it is still worth taking whatever steps you can to groom the business as these will pay off and a higher price will be achieved.

The main areas to consider on preparing a business for sale are:

• profiling the profits
• polishing the plant
• preparing the paperwork
• providing peace of mind.

PROFILING THE PROFITS

As has been discussed, a purchaser is principally going to be interested in knowing how much profit the business may be expected to make going forwards, as they are essentially buying that future stream of profits (and cash).

Set out below are the recent profit profiles of four companies, each of which in the last year generated a profit of £50,000, together with a purchaser’s likely reaction to the profile shown.

A purchaser would make no assumption or allowance for growth in coming up with a purchase price for Company A.

With Company B, the purchaser might actually assume that profits are likely to fall in the near future, as a result of an industry shakeout.

Whilst Company C can make extremely good profits, it also has the risk of making extremely poor ones, and a purchaser would discount the multiple they would apply to profits to reflect this fact.

Company D shows a strong, steady growth in profits over a number of years and, unless there is some major shock in the wings, the purchaser would take comfort from this strong track record when projecting forwards future expected earnings.

Therefore to achieve the best sales price for your business, your profit and growth track record should look as much like Company D’s as possible.

There are also a number of areas in respect of finance that will need attention in the years prior to a sale, both in order to be able to demonstrate the actual profitability of the business and also in order to make the sale as easy as possible. The key areas for action are summarised below.

Have your accounts audited

Even if your business is exempt from producing audited accounts, consider having your accounts audited from this point forwards.

In a strict legal sense, your purchaser will not be able to rely on the audited accounts, since the accountant’s opinion is not actually addressed to them and they would have significant difficulty in holding the auditors to account for their report. In addition, since the purchaser will be conducting their own due diligence using their own firm of accountants to audit your results and your status, why should you bother with the expense of obtaining audited accounts?

Accounts, however, that have been audited carry a significantly higher level of credibility than unaudited ones. They therefore help to demonstrate your confidence in your business’s performance and its systems for recording its performance, as well as providing comfort for the purchaser and that the numbers upon which they are basing their decision have some basis in reality.

Operate ethically

Following on from using professional advisors to audit your accounts, if you are engaged in any special arrangements designed in order to avoid paying tax you should stop immediately for a number of reasons. If you want an audit opinion, you want a clean audit opinion, not one that is qualified over disputes on revenue recognition or failure of your accounting systems to record all the company’s business.

Remember that when considering what to pay for the business, the buyer will be looking at the recognisable underlying profits of the business. When considering what to pay for a stream of income, the buyer will only really recognise easily traceable and easily reconstructable profits. Would you pay a multiple of six times earnings for earnings that could not be seen in the books of accounts of the business you are buying? The buyer will not want to pay a multiple of profits that are not easily and clearly demonstrable.

Diversion of earnings in order to save tax therefore has two adverse effects. First it depresses the price you are likely to achieve because if a buyer is paying a multiple of earnings they won’t pay that multiple for things they cannot see. Secondly, you will depress the price or may even lose the sale altogether because the buyer will think they are buying from a crook. The buyer will have to factor that knowledge about your business ethics into their calculations about what multiple to pay, what risks they are running in purchasing the business from somebody with that attitude, what potential liabilities it may give rise to later (eg as a result of a subsequent tax investigation) and, indeed, whether to go ahead with the purchase at all, given the risks that all this may involve.

When looking at selling a business it pays to invest in paying taxes for a number of years, bearing in mind that if you achieve a sale at a multiple of six or seven times earnings, you will recover this money many times over on the eventual sale.

Rationalise the business

As they grow, many businesses acquire a variety of peripheral areas of activity arising out of, or related to, their core business. Some of these additional activities may be significant contributors to profit, others may be more marginal. In the sale of your business, you will be looking to demonstrate clear profitability. If your business has a large variety of peripheral or add-on areas of activity that confuse the picture, this may not help you in being able to show a purchaser the clear strong performance of the core business you wish to demonstrate.

Therefore, a number of years before looking for a sale, take a step back and review your business. Identify its core business and assess how strong, profit-making and cohesive a group they are. Review carefully all the ancillary, marginal or non-core activities. Those that have a clear market position and strong profitability you may well wish to keep in order to bolster the profitability of the core business. Those that simply confuse the picture, or give poor returns, you should either turn around or dispose of in advance of your main sale so as to be able to show a clear, easy to understand picture of a well focused business with strong central profits.

Clean the balance sheet

In addition to a clear picture of profits, you also need to be able to provide a clear picture of the balance sheet. Therefore a part of the preparation for sale involves cleaning up the balance sheet. The longer term issues involve identifying company assets (such as land and buildings) which you wish to remove from the company prior to the sale.

In the medium term, you need to review liabilities which may cause problems to a purchaser’s due diligence. Specific issues tend to be shareholder loans which complicate the picture and which, where possible, should be paid back prior to going in to a sales process; and intercompany trading accounts which the purchaser will need to review in detail in order to see what the true asset and liability position is of each business as a standalone entity, together with identifying whether the turnover and profitability of any of the businesses has been artificially inflated by means of intercompany trading.

Clean the current assets

Finally, in the short term, before going into a sale, review your stocks and purchase and sales ledger (aged creditors and aged debtors). Where there are old or doubtful debts or slow moving items of stock, these should be written off. There are two reasons for this. First when your purchaser’s accountants go through their due diligence process, they like to pick up these items anyway and they will be used against you in order to negotiate down the purchase price. Secondly, by recognising them now, prior to a sale, you can actually get value out of them, because as specific write-offs they should be allowable for tax and will therefore minimise your tax liability in the year coming up to sale.

POLISHING THE PLANT

The way your factory, offices, plant, equipment and stock are kept will make a significant impression on purchasers when they first visit your premises, not only about the plant and equipment itself, but also about how efficiently the business is operated and how reliable the controls are likely to be.

If you visit a plant that looks a complete shambles, this does not inspire confidence in that company’s accounts, or in the accuracy of the costing information you will receive.

If you visit a company where the production environment is spic and span, the machines look well tended and maintained, the flow of goods through the factory is orderly, and the stock looks well segregated and identified, you will start out by having more confidence that any accounting information about profits or costings has a better chance of being accurate.

And let’s not forget, the purchaser’s purchase price is likely to be based on a multiple of profits, and the multiple they are prepared to put on it is a measure in some degree of their confidence in both the underlying current profitability and the risks associated with future projections. You should be allowing nothing to happen in your business that has any possibility of undermining a prospective purchaser’s confidence in the business or its figures at any time during the sales process.

The premises and plant and equipment should therefore be painted, and any repairs needed should be undertaken. Obsolete plant and equipment should be disposed of so that it does not clutter the place up. Stock should be quite clearly segregated into tidy and clearly identifiable spaces, with racking installed with clearly identified bay numbers for location of stock (that should then tie up to the stock records). Where stock or cartons have to be stacked, stacks should be neat and tidy and pallets or cartons should be arranged neatly in rows or at right angles to each other as this helps to give an impression of order. Any land around the factory should be tidy and well maintained. Recognise that the reception area sets the tone for people’s expectations of the business and should therefore be fitted out and kept tidy and professional in appearance.

Go through the offices and ensure that filing is tidy and put away, loose papers are cleared up or disposed of.

It is not possible to overemphasise the difference in perceived value between visiting a plant that is clean and crisp in appearance as compared to one that is a mess.

You will also find that your employees will be much more productive in a business that is well organised and will make a favourable impact on the buyer.

Review the flow of work through the premises. Stock and raw materials should ideally come in at one end, follow a logical process through the production process sequences throughout the factory and exit at the other end as finished goods, straight out on to a lorry and out to the customer. If your processing involves a lot of moving goods from one station to another in no apparent logical order, consider reorganising the plant and equipment so that you do get a sensible workflow.

A particularly tricky issue during a prolonged presale grooming process is whether or not you should invest in upgrading plant and equipment or premises in the years leading up to a sale. Dependent on the business’s circumstances, this can have a major impact on its value.

It is difficult to give a hard and fast rule as to whether you should undertake such projects or not. The downside is the degree of expenditure and cost that may not be reflected in increased value of the assets being sold. And if you are going to invest in major change, such as for example installing a new IT system, or relocating plant and equipment, in addition to the actual purchase cost, appreciate you may well also suffer further costs through disruption and upheaval in your existing business operations.

Against this must be set the potential writing down of the multiple that a prospective purchaser will apply to your business on the basis that its plant and equipment, systems, or premises are out of date and will require investment following the purchase.

If you do go ahead with a major investment or change, you must ensure that it is completed before you enter into the actual sale process. Stepping into the purchaser’s shoes for a moment, who would want to buy a business that is in the middle of a major change in its operations, plant and equipment or systems, and suffering from all the associated disruption? Major projects are often the ‘straws’ that break the camel’s back and that can lead to a business failure (see Turning Your Business Around, Mark Blayney) and the uncertainty and disruption associated with the business during a major change will lead a purchaser to discount what they are prepared to pay as a result of the extra risk this carries.

When contemplating whether to invest in new plant, equipment or systems, bear in mind that your business has not been sold until it has actually been sold. Therefore I recommend continuing to trade your business throughout the period leading up to and through a sale as though the sale were not going to take place. On this argument, if it makes sense for your business to invest in items of plant, machinery, equipment, or a new IT system, then that is what you should do, irrespective of the fact that you may at the same time be contemplating selling. Consult with your advisors during your sale planning and if you do invest comfort yourself with the idea that it will help you to negotiate a good price for your business when you do come to sell, since your investment is there to protect the future earnings of the business and therefore reduces the risk and increases the multiple that the purchaser ought to be willing to pay you for the business.

PREPARING THE PAPERWORK

The sorts of items that will be reviewed by the purchaser’s advisors during due diligence are covered in Chapters 10 and 11 while typical checklists of financial and legal documents to be requested from a company being sold are given in Chapter 10. Since you want the sale to go ahead as smoothly as possible with the minimum of surprises and ammunition for the purchaser to reduce their offer price as a result of items found during due diligence, the first thing to do is to ensure that all your books and records are tidy and up to date.

Given the variety of areas that are looked at under a due diligence, you need to interpret books and records very widely to include not only your accounting records and your regular management accounts, profit and loss, balance sheet, cashflow forecasts, and aged debtor and creditor lists, but also your payroll and tax record and your company secretarial records such as register of charges, minute book and share register.

In addition to these, there are then a variety of operational and commercial matters which need to be kept up to date, such as files on banking arrangements and facilities in place; any distribution or licensing agreements; your trademarks, copyright, patents, and other intellectual property; and your commercial agreements, such as leases or contracts.

You should use the checklists in Chapter 10 to review this area well in advance of the sales process to give yourself time to resolve any problems discovered.

You should also ensure that all items which need to be codified into contracts have been. Check to ensure that you have contracts of employment for your employees and your directors and put together a file containing copies of the lease for your premises, and leases on all key items of plant and equipment.

As the purchaser is broadly interested in the future underlying profits of the business, the more certain the future results are the better you are able to justify a higher multiple. One way of attempting to improve certainty is by reducing the risk of specific changes, for example a purchaser may be extremely concerned that relationships with a group of customers or suppliers are dependent upon your personal contact with them over a number of years and the risk that these relationships may not be reliable once you have sold the business. This concern may then cause the purchaser to reduce the multiple they are prepared to pay for it. One way to try to reduce this apparent risk to the purchaser is by turning such relationships with customers or suppliers, wherever possible, into contractual agreements.

By doing so you can argue to the purchaser that you have reduced the purchaser’s reliance on simple goodwill and relationships and replaced this with a legal contractual relationship on which the purchaser can rely.

Whether a relationship has been codified into a contract or not, you will need to give careful thought, again as part of the grooming for sale process, as to how relationships are to be managed during transition to the new owners.

At the same time, review your existing key contracts and identify any that will expire shortly after your proposed sale. Consider renegotiating any such contracts so that at the time of the sale the purchaser will have the certainty of the contract going forwards for a number of years. Again, by reducing this uncertainty you will reduce their perceived risk as to the sustainability of the projected profits and thereby help to improve the multiple obtained.

Check to ensure you have not entered into any commitments that would actively prevent you from selling. Some soft loans (for example a loan from a brewery to refurbish a pub or nightclub) may come with a condition that the owner does not sell the business for a specified period, so that the brewery can ensure it gains the full advantage that is expected from having made the loan. Similar conditions might be attached to grants, where on the event of the sale of the business to owners within a specified period, the grant is repayable.

Landlords

Where the ownership of a business is going to change, for example a sale of the business and assets of Company A to a purchaser Company B, or the sale of a business by individual Mr A to Company B, the position of the landlords is vital as they often have the power to kill deals. They therefore need to be involved in the process early enough.

In theory almost all property leases are transferable to a new owner (assignable) as they will generally include a clause allowing assignment. This clause is usually qualified in that the landlord has to provide consent to the sale although this consent should not be unreasonably withheld.

So what is reasonable or unreasonable in these circumstances? Well, when granting a lease to a tenant a landlord will undertake a variety of credit checks to ensure that the tenant is likely to be able to pay the rent whilst in occupation. If the tenant then decides to sell the lease on to another prospective tenant, the landlord will want to ensure that the new tenant is at least as able to pay the rent as the old tenant. A tenant’s perceived financial strength and ability to pay the rent is known as its ‘covenant’. A prospective tenant who is clearly financially strong and able to pay the rent going forwards is a strong covenant; a tenant where there may be significant doubts about the strength of their cashflow and therefore their ability to pay the rent is a weak covenant.

In looking at a proposed transfer of ownership from the existing tenant to a new tenant, the landlord will be looking to ensure that they are not weakening the covenant in relation to the premises.

Similar considerations to those of landlords will apply to a range of franchise businesses, tied distributors of certain products (such as car main dealers) or users of licensed trademarks or brand names.

PROVIDING PEACE OF MIND

When looking to groom your business for sale, try to put yourself into the prospective purchaser’s shoes. Looking at your business from the buyer’s point of view, if you were thinking about buying your business, what aspects of it would worry you the most? There is a very natural human tendency to look at the strengths and weaknesses of your operation and spend time polishing the strengths. But when a purchaser is coming along to look at your business, what they are most worried about are the risks that arise out of the weaknesses. Therefore, you need to consider your business critically to identify the weakest parts of it for most concerted action.

Accounting systems

Bearing in mind that your purchaser will bring in a team of accountants to undertake the due diligence process, first and foremost you need to be able to demonstrate that you have adequate financial systems and controls in place. After all, these will be accountants reviewing your business, so what do you think they will want to ensure they have covered properly?

However, this is not just a case of professional pride. The buyer will need to feel comfortable that you operated and are still operating good financial systems as, in making a judgement as to what multiple to apply to earnings, they need to be confident that not only is the existing earnings figure broadly correct but that they can understand what is going on so as to adequately be able to judge the strengths or weaknesses of existing and projected income. The buyer will need to be confident that they understand all the business’s liabilities and that these are all recorded in the company’s books and have been recognised as a cost. They will also need to be sure that stock has been correctly quantified and costed and that prices quoted on contracts have been calculated on a sensible basis so as to make a profit. Each of these areas relies on an efficient accounting system.

Management team

The purchaser will also be aware that in order to deliver the projected income they need management in place who are able to manage the business to obtain the results. So, particularly where you are looking to retire as part of the sale, a vital part of grooming the business for sale is building an adequate management team who we tied into the business and will be able to carry on once you have left and to put in place management and information systems that capture your specialised knowledge so that this is clearly in place for the purchaser going forwards.

Again, what the buyer will be looking for is comfort that current earnings will lead through to projected future earnings. This implies a high degree of continuity between the trends before and after the sale which can only really be delivered if there is a strong management team committed to the business and which transfers across with the business on sale. If you are building a business that is completely dependent upon you, your skills, your contacts, and your management of the business, without a management team that could survive without you, you are not building a saleable business, you are running a one-man band that will not survive you. A business run by an owner with a team of managers in place who are anxious, willing and able to take the business forward is much more attractive to a prospective purchaser.

Outstanding practical issues

As part of the commercial due diligence, the purchaser will want to look at a range of operational and commercial issues. So now is the time to look hard at all the operational issues in your business, such as rate of customer returns, complaints and credit notes required, quality problems, and scrap rates so that when the purchaser’s accountants come to review these statistics, they will all be at acceptable levels.

Environmental risks

Finally, you should not forget environmental issues when grooming your business for sale.

The potential costs of environmental issues have driven this item up in purchasers’ concerns over the last few years. You will find that many buyers are likely to ask for warranties in respect of environmental issues, so it is good practice to have an environmental audit done well in advance so that any issues arising can be resolved by you in advance of any due diligence undertaken by the prospective purchaser. Alternatively you can then have a second environmental audit done to demonstrate the problems have been dealt with.

Whilst on the subject of these types of external audits, where appropriate you should maintain records of external insurance, fire safety, and health and safety reviews, and the actions taken to respond to any points raised, as these may also be looked at as part of a due diligence exercise.

THE ADVANTAGES OF BEING WELL GROOMED

Grooming performs two vital functions. First it is designed to make your business as interesting and as attractive to a prospective purchaser as possible, so as to ensure they make the best offer possible for the business and are as keen as possible to buy it. Secondly, combined with a ‘mock due diligence’ exercise, it is designed to ensure that the sales process thereafter, including the due diligence carried out by the purchaser’s advisors, goes as smoothly as possible, gives rise to as few hitches as possible, and certainly gives rise to no unpleasant surprises or grounds on which the purchaser can seek to negotiate the price downwards.

It is therefore designed to help support getting both the best price in the sale and the sale through as smoothly as possible.

Time invested in preparing the business for sale will repay itself many times over in a less risky and more rewarding sales process.