VALUATIONS ARE VALUELESS

The fundamental reason for buying and the one which drives most consideration of valuation, is to make money from the business.

Business valuation is a mix of art and science and, how much a buyer will be prepared to pay can depend not only on the nature and finances of your business, but also on the nature and finances of theirs.

In addition the strategic reasons that buyers may have for wanting to acquire your business can include:

• to rapidly enter a new market
• to rapidly increase market share in an existing market
• to take out a competitor
• to turn around a loss-making business
• to acquire new technology or other significant asset.

In some cases therefore, as a result of the buyer’s reason for wanting to buy, 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.

Case study 1 – The strategically important niche

The business manufactured a basic commodity product, the characteristics of which tended to mean that in any particular geographical area there would only be one supplier as a result of both the scale of operation required and the costs of moving finished goods over long distances.

The industry had therefore grown up based on a network of independent producers, each dominant in their own local territory but now consolidating. Essentially there were now two big players who were expanding by purchasing the local operators. One consolidator was expanding from south to north, the other was moving from west to east.

This particular business was one of the last independent operators and was located in the north east. As a basic commodity business with little perceived scope for adding on extra services or new uses, there was no perceived interest from players outside the industry. For the two expanding companies, however, the business was potentially a key strategic acquisition in terms of establishing who was going to be the dominant regional supplier.

The owners of the business had had a valuation done based on some of the techniques concerning current and future profitability discussed in this and the following chapter.

In practice, we adopted a strategy that was potentially dangerous in that we arranged for representatives of both consolidators to visit the factory on the same day. In doing so, each saw that the other was potentially interested in purchasing the business.

The risk in this strategy was twofold in that either they might get together and combine to offer a joint bid, with a view to cooperating in running the business as a joint venture or agreeing to split it up at some later date, having used this technique to drive down the price that the seller could obtain. Alternatively they might each resent being forced into competition and decide to sit out the bid. In practice what happened was that one of the consolidators decided to do exactly that and refused to enter a bid. This left us exposed so that if one consolidator knew the other was no longer in the running, they could put in a low bid knowing they had no competition.

However, it was not in the other consolidator’s interests to allow its rival to snap up the business cheaply, so they kept quiet about the fact that they had dropped out of the bidding. In the event, the west-east consolidator ended up making an offer for the business including a number of assets they did not really want, at 50% greater than the expected valuation the company had obtained in the first place. They did so in order to ensure that it did not fall into the hands of their rivals because it was such a key strategic fit.

In practice, the acquisition proved not to be a success partly because they had overpaid; partly because in planning what they were going to do after the acquisition they had failed to adequately plan for the investment required to upgrade the company’s facilities; but most importantly they had failed to undertake proper commercial due diligence in respect of the people issues. Following the acquisition they had put in place a management team that had rapidly come into conflict both with the new owner’s main board and the staff within the company acquired due to mismatch of cultures. The result is that the business performed extremely poorly following the acquisition.

Case study 2 – The hidden asset

The business manufactured and sold a type of drinks dispenser together with the consumables supplied to go into it. It was a relatively small operation that was essentially a one-man band who ran it as a ‘lifestyle’ business. The business was sold in a relatively straightforward way and the seller was pleased to obtain a significant premium over the value he was expecting.

As a matter of interest, the advisors followed up the sale some six months later, asking the purchasers how they were getting on and what sales they were obtaining of the product. The response from the purchasers was somewhat surprising, being to the effect: ‘Actually we don’t really know what we are getting in terms of sales of the product, but really we aren’t that bothered.’ The reason for this indifference was fairly simple, the purchasers had not purchased the business to obtain the existing trade (i.e. its sales of its drinks dispenser and the consumables). Whilst the purchaser was happy to have those sales, the real value of the deal to the purchaser was the distribution network and the opportunity it gave to get into the companies who were buying the company’s drinks product. In fact, the purchaser was using this distribution network as an additional sales channel for its own core products and through this distribution network was now selling over ten times the value of its own products (non drinks) in comparison with the sales the target company’s drinks dispensing consumables had ever achieved.

The value of the business to the purchaser was therefore nothing to do with the underlying trading ability of the company and its own products, but rather to do with its potential as a sales channel.

Case study 3 – Pride and prejudice

And you should never underestimate the personal element in respect of any purchase. Takeovers (Fallon, Ivan, and Srodes; James, London, Hamish Hamilton 1987) covers many of the big business bidding battles of the 1980s and is filled with examples where winning a contest to buy a business became a matter of ego and pride for aggressive chief executives, and therefore where the commercial logic and questions of return on the investment seem to have gone out of the window.

Following the collapse of the Socialist bloc, I was involved in selling ‘bust’ businesses in a previously Socialist country. One of the cases involved a toilet paper manufacturer, which was in such a poor state that the machinery could no longer reliably put the perforations into the rolls.

Nevertheless, we marketed the business and quickly obtained a very strong offer to purchase it which gave us a significant premium over any reasonable ‘normal’ valuation of the business. A number of months following the sale I contacted the new local manager to enquire how the business was progressing and whether the buyer was happy with his purchase.

The reply was that the new owner would be happy with the purchase even if it was making no toilet rolls. In discussion, the background then came out. Before liberalisation, under the country’s planned economy, every factory or operation had had to be licensed by the authorities to operate. The purchaser had applied for a licence to set up a toilet paper manufacturing company and the authorities had agreed that the country needed one such factory. He had started to set up in business when, to his surprise, the licence to operate such a factory was awarded to someone else, without any expertise in producing paper, but with good political connections. The purchaser had then travelled abroad and set up (successfully) in business elsewhere.

The news that this toilet paper business, which he had always regarded as having been stolen from him, had now collapsed, was bust, and was available to be purchased at a price that was (for him) a bargain, represented a chance to get his revenge upon both the licensing authorities and the person he believed had stolen the business from him in the first place.

Valuing issues

From the above three cases, you can clearly see that in addition to what might be considered the normal commercial justification for buying a business in respect of the business’s ‘own’ business and its prospects for making money, there may be strategic issues for a purchaser in terms of snapping up a key territory or getting access to channels down which it can pass its own merchandise; or very personal matters, which can lead a purchaser to pay significantly more than might otherwise be expected for a business as it stands.

Valuing 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 your particular business until the day you decide to put it up for sale.

There are, however, a variety of financial bases for valuing businesses that will give a range of possible valuations depending on the assumptions used. The bases of these approaches to valuation are detailed in Chapter 4.

So, if financial based valuations give a range of values which may in the end be completely irrelevant to the value the purchaser places on the business and is therefore prepared to pay, why have a valuation at all?

THE VALUE OF VALUATIONS

Nevertheless, it is useful to have a valuation exercise done as part of the process at the outset. The exercise in quantifying the potential value of the business to others can help you in:

• Identifying assets which you would rather keep than sell (eg the land and buildings) and might therefore be best excluded from the sale.
• Identifying financial risks existing in the current business (eg your personal guarantee of the bank overdraft) which will need to be dealt with by way of the sale.
• Identifying how best to groom the business for sale so as to get the best price.
• Understanding the range of possible valuations that will be placed on the business by different purchasers and the basis on which they and their advisors will arrive at these (which obviously also helps you on how to groom the business for sale to achieve the best price).
• Ensuring you have a realistic expectation of the price achievable for your business.
• Helping you quantify the price below which you are not prepared to go (your ‘drop-dead’ price) as it makes more sense to continue in business.

The buyer’s advisors will, in any event, be undertaking a valuation exercise to assist the purchaser in deciding whether or not to make the investment. They will be using the same valuation methods as your advisors will be using to advise you how much it might sell for. Therefore, by undertaking the exercise you have the basis for discussion between the professional advisors.

Valuations will generally be done on a ‘cash now’ basis, which 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.

THE DANGER OF OVER-RELIANCE ON VALUATIONS

As a general word of warning, before getting into price negotiations with a prospective purchaser you should have engaged professional assistance experienced in such negotiations.

Example

A trade purchaser was looking to buy some businesses in a particular sector and approached company A to see whether it might be for sale.

Company A was interested in selling.

The owner of company A spoke to his accountant, who advised him that he understood the business would normally be worth twice its annual profits. So company A started the conversation with the prospective purchaser by saying: ‘My accountant thinks my business is potentially worth £X.’

The result was that £X became the starting point from which the purchaser was looking to negotiate the price downwards. The inevitable result was that the business could only be sold for something less than £X.

Having spoken to the accountant and obtained the valuation, what he should have done was to decide to keep this figure in mind as its bottom line drop-dead figure and engaged a corporate finance advisor. The corporate finance advisor would then make contact with the enquiring company and say: ‘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 would be that in order to proceed, the acquiring company has to give an indication of either the sum of money it is thinking about paying, or the basis on which that sum will be calculated. Therefore, if the purchasing company has specific reasons for wanting to acquire the business which would lead it to pay more than the ‘normal’ multiple mentioned by the accountant (as in the cases already discussed), their offer price might be significantly in excess of the accountant’s estimated valuation. The company can then start negotiations without having given away either its bottom line or its target price.

Having both a target price and a drop-dead price in mind during negotiations will make these negotiations more effective. You will be able to kill negotiations that are not going to deliver your drop-dead price. Once you have achieved your target price this gives you the basis on which to consider the risks of continuing to negotiate in the hopes of getting a deal that significantly exceeds it, versus the benefits to be gained by accepting and moving to close a deal that achieves, or slightly exceeds, your target price.

Don’t blow a good deal by being greedy.

BASIS OF VALUATION

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

Asset valuation	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 hack to a present value (or an implied internal rate of return that investing in the purchase of your 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 your business, or the price/earnings ratio (which is the price they pay for your 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 (eg 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 4.

WHAT’S FOR SALE?

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

What type of sale will it be?

There are two principal methods for selling an incorporated business (ie a limited liability company). You can either sell the company by selling the shares in it, or the company can sell the business and assets the company owns.

While this raises a number of issues, for the purpose of considering valuation at this stage it is enough to note that you as an owner may well prefer to sell your shares (ie the company) since this will generally lead to a single tax hit in respect of Capital Gains Tax on the value of the shares (see Chapter 13).

However, a purchaser may wish to buy the business and assets from the company, rather than the company itself, so as to enable them to acquire the individual assets at ‘fair value’ for incorporation on their balance sheet. This approach also helps the purchaser in restricting the potential for taking on unknown or contingent liabilities as part of the deal.

The difficulty for you in a sale of the business and assets is that obviously the company may be taxed on the proceeds of its sale of the business and assets, and then you may face tax again on attempting to get the proceeds of the sale out of the company and into the hands of the shareholders. You may therefore seek to get the purchaser to pay a higher value for the right to buy the business and assets rather than the shares.

What assets are included?

The second principal consideration affecting value is what in particular 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 business owner and an arrangement made to rent the property to the owner of the new business, so as to provide an income stream for the business owner in retirement. Obviously the value of the business that has its own freehold property will be different from the value of a business that has to rent its property from the previous owner as a landlord.

What liabilities are the new owners going to acquire?

As the owner-manager of a business you may well have had to guarantee certain of the company’s borrowings, such as an overdraft, or perhaps leases. When you sell the business on to another party, you will want to ensure that your liability is extinguished. 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, together with the impact of meeting over time the company’s normal business obligations such as payment of existing trade creditors.

DO YOU HAVE A SALEABLE BUSINESS?

Many people, such as a consultant I worked with who was earning £350,000 in a good year, build up successful businesses that provide them with a good income but which are, however, inherently unsaleable.

If you have a business that is completely based upon your personal network of contacts or upon your personal skills, whilst this may be a successful business and provide you with a good living, it is essentially a lifestyle rather than a saleable business. This is because you are, in essence, the business. Crucially, the business has no life outside of you and your skills and contacts. Therefore there is nothing for anyone to buy, as on your retirement those people who come to you because of your contact with them will have no reason to come to the person who has bought your business.

Similarly, if people come to your business because of your specialised knowledge, why should they come to the business once you are no longer there?

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

If you have such a business and you wish to be able to sell it, you need to take steps to ‘institutionalise’ your knowledge or contacts into the business so that the business has some life outside of you.

So, if the business is based around a 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. You need to engage sales staff in order to use this contact database and generate more income independent of your personal working of this network. From this you can look to develop the business’s brand name such that people who aren’t directly known to you or who come across your business through third parties or through reputation will start to use the business. Similarly, if the business is built around your own specialist knowledge, again in order to have something which is worthwhile to sell, you will have to start to institutionalise this into a database of information, operating systems, processes, or some other mechanisms whereby the value of what you know can be transferred to others.

In practice the people for whom this will have most obvious value will be the people you bring in to your business, perhaps at first as employees or junior partners who you may then allow to buy you out over time.

Of course there are risks in moving from a one-man band to a business with a structure and a greater number of employees. Not least, where you are attempting to transfer the knowledge or contacts which form the basis of your business into a form that can be transferred to others they are therefore potentially at risk of being used by others without due benefit to yourself. As a result, part of the process of protecting what you are doing will be to ensure that staff being brought in sign proper terms and conditions that allow you to prevent them using any knowledge passing across them without having paid for it.