1 Selling a Business A Strategy for Success Peter Gray Cavendish Corporate Finance LLP 40 Portland Place London W1B 1NB Direct line Mobile Switchboard Facsimile
2 About the Author Peter Gray is a partner with Cavendish Corporate Finance LLP. Mr Gray joined Cavendish in Since, then he has been personally involved in the sale of over 50 companies including a number of household names such as Avent Baby Products, Plymouth Gin and Antler Luggage. Prior to joining Cavendish, Mr Gray worked as a corporate lawyer with Clifford Chance in its management buy-out group. Mr Gray has degrees in Law and Economics from the University of Melbourne and an MBA. He is a frequent lecturer and author on the subject of selling private companies. Contents 1. Introduction 5 2. Making the decision to sell and timing a sale 6 3. Preparing a business for sale 18 About Cavendish Corporate Finance LLP Cavendish Corporate Finance is the UK s leading independent specialist adviser to vendors of businesses. Founded in 1988, Cavendish has advised on some 400 company sales with an aggregate value in excess of 3 billion. Cavendish focuses on the sale of private companies falling broadly within the 5 million to 150 million value range. Cavendish is unique in that it has only ever acted for vendors of businesses. As a result, it enjoys unrivalled specialist expertise in managing the company sale process. Cavendish never faces the potential conflicts of interest experienced by firms who advise both purchasers and vendors. Cavendish is a member of M&A International Inc., the world s leading alliance of specialist mergers and acquisitions advisers. With 41 offices in 40 countries, M&A International offers unparalleled global coverage and access to the international market through local representation. 4. Appointing advisers Valuation Developing a media strategy The sale process Identifying potential purchasers Disseminating information Approaching potential purchasers The negotiating process Due diligence and warranties Risk minimisation tools Conclusion 87
3 Introduction The sale of a business is a complex and, in many cases, life-changing and highly emotional event. It is also a complex exercise, generally taking at least six months and sometimes several years if one includes the preparation time which is often involved. The complexity of a sale exercise comes from the large number of elements in the process valuing the business, timing a sale correctly, finding the right buyer, negotiating price and other terms, the due diligence process and then actually concluding the transaction. Achieving a successful outcome requires excellent planning, a lot of hard work, the right advice and often, a large slice of good fortune. This book aims to demystify the sale process and help you achieve the best possible outcome when selling your business. It describes each element of the sale process and illustrates key messages with real life examples of successful company sales on which Cavendish Corporate Finance has advised the vendor.
4 MAKING A DECISION TO SELL AND TIMING THE SALE 7 Chapter 1 Making the decision to sell and timing a sale If, on the other hand, you are relatively young, wish to remain with the business and have little or no immediate need for cash, a flotation may be the preferred choice. Alternatively, you may wish to hedge your bets by realising part of your equity but retaining the balance for an exit at (hopefully) a higher valuation in the future. As always, it is a case of matching the exit route with your objectives. Choice of Exit Route depends on objectives Selling your business, which may represent a life time s work, ranks as one of the most important decisions you will ever take. It will hopefully result in you realising the value you have created in the business and achieving financial nirvana but there are many traps along the way for the unwary. It is always essential therefore to ensure that a sale represents the best course of action and, if so, that it is the right time to sell. Caution OBJECTIVES TYPE OF EXIT Cash Out/ Retirement 100 % Sale Part Cash Out/ Retention of Equity Partial sale to Private Equity House or sale to Strategic Buyer with long earn out Determining the right exit route Ambition No Cash Out Capital Growth Flotation/Growth Capital The first task when considering a sale of your business is to determine your objectives, both financial and otherwise. You must then determine whether those objectives are likely to be achieved by selling your business or whether there is a preferable exit route. There are a number of different routes for you to realise value for your business. These include: sale of 100% of your company; partial sale of some of your equity in the company; or stock market flotation. In many cases, not all of these options will be available. For example, a company may be too small or may not have a sufficient profit track record for a flotation or alternatively, market conditions may preclude it. Where there is a choice of exit routes, your objectives will determine which of these routes represents the best alternative. If you wish to retire and realise cash for your shares in the company, a sale of 100% of the business is the only viable option. Is the company saleable? Where you have decided, in principle, to sell your business following a review of your objectives and the various alternatives, you must then determine whether a sale will be a viable option. A sale may simply not be possible for a number of reasons. For example, the business may be totally dependent on you or has a single customer or the business model may be fatally flawed (e.g. Woolworths). Alternatively, the company may operate in an industry which is in terminal decline. Clearly some of these impediments to a sale can be remedied while others cannot. There will also be situations where a sale may be a viable option but the likely valuation would be so low, it would not be in your interests to sell it. Even where a sale might be an appropriate exit route, it may not be the optimal time to sell. The company s growth profile, the current size of the business, market conditions and a host of other factors may dictate that a sale should be deferred.
5 8 SELLING A BUSINESS: A STRATEGY FOR SUCCESS MAKING A DECISION TO SELL AND TIMING THE SALE 9 Issues with multiple shareholders Consideration of the objectives of the shareholders is especially important where your company has several shareholders with different agendas which may give rise to potential conflicts of interest. As far as possible, the exit strategy chosen must fit with the needs of all interested parties, including members of the management team who are not shareholders of the business. Examples of conflicts between shareholders include: some shareholders may seek the entire consideration up front on completion while others may be looking to achieve a higher price through an earnout. Alternatively, some may be prepared to take shares in the purchaser while others may not; some shareholders, who are also directors or employees, may seek a purchaser who will enhance their careers and employment prospects; and where there is an institutional shareholder as well as management shareholders, the institution will not be prepared to give warranties but will expect the management to do so. In some cases where there are multiple shareholders, the shareholders will enter into a formal memorandum in advance of the sale which covers issues such as the minimum price expectation, willingness to remain with the business following a sale, willingness to give warranties to the purchaser and the type of consideration which is acceptable. This can be an extremely useful exercise in flushing out issues prior to the sale but even in the absence of such a memorandum, a consensus needs to be achieved amongst the shareholders on those matters. Disputes between shareholders once the sale process is underway need to be avoided at all costs. Reasons for a sale There are myriad reasons why you might consider selling your company. The most frequent reason for considering a sale is to realise capital, either for financial security or to invest in other projects. There is, however, rarely one reason alone, but generally a combination of the following: Case study : Maximuscle Partial sale to private equity Founded in 1995 by Zef Eisenberg, a former body builder, Maximuscle produces and markets sports nutrition products for athletes, fitness enthusiasts and gym goers. Zef, at that time, the sole owner of the business and just 29 years old, approached us with three very clear objectives in mind: to realise a significant proportion of the value of Maximuscle in cash but to maintain a meaningful equity stake, as he believed (quite rightly as it transpired) that the business still had huge growth potential; to bring in an investor who could take the business to the next stage; and to bring in a professional management team to allow him to focus on his two passions of product development and marketing. Following further discussions with Zef, it was clear that these objectives would be best achieved by a partial sale to a private equity firm. Following a competitive process, Piper Private Equity was selected as preferred bidder on the basis of its expertise in growing branded consumer businesses. In parallel, Paul Hick, formerly Chief Executive of Lee Cooper, was recruited as Chairman and Ivor Harrison, formerly CEO of Premier Foods, brought in as CEO. Following the investment by Piper at a valuation of around 10m, Paul Hick and the management team successfully moved the business into more mainstream sports drinks and away from its bodybuilding roots. They also established new routes to market through wholesaling to the retail multiples. This resulted in top-line growth of over 20 percent per year over a three year period following the transaction. During this time, Zef was able to focus on the parts of the business he enjoyed and let the CEO deal with the day to day running of the business. In 2008, a subsequent sale to Darwin Private Equity for over 75 million realised a further substantial cash sum for Zef more than doubling his proceeds from the original sale.
6 10 SELLING A BUSINESS: A STRATEGY FOR SUCCESS MAKING A DECISION TO SELL AND TIMING THE SALE 11 the recognition that the business has reached a peak or a target valuation; the realisation that the business cannot grow further without a significant capital injection; the need to access new markets by being part of a large, possibly international, group; the business has reached a size where the owner feels unable or unwilling to manage it; a disagreement among shareholders means that the business is no longer manageable under existing ownership; the only alternatives are closure or receivership; an imminent retirement/succession issue; or an approach has been received from a credible buyer or buyers of the business. For a group of companies, possible reasons for the sale of a business include: the business may no longer fit within the group s core activities or future strategy; the business may have been a poor acquisition; or the group may have to sell because of liquidity problems. In addition to company specific factors, there are a number of external factors which may instigate a sale. These include: Getting the timing right Introduction Timing a sale process correctly is particularly important given the damaging consequences of an aborted or unsuccessful sale process. The sale process often distracts management from running the business, which may adversely impact the performance of the business. In addition, if a business is placed on the market several times and then withdrawn, the business may gain a reputation for being permanently for sale, which can damage relationships with suppliers and customers as well as act as a deterrent to future bidders. In common with the sale of any investment, it is extremely difficult to pick the optimal time to sell your business. There are, however, some general rules outlined below to which regard should always be had. Market conditions You must have regard not only to the performance of your business in timing a sale, but also to the current state of the M&A market. The more buoyant the M&A market, the easier it will be to sell your business and the higher the valuation that you will achieve. The table below shows M&A activity levels by both value and volume of deals over the past 12 years. UK Mergers and Acquisitions by Volume/Value a bubble in the sector has resulted in high valuations, or there are concerns that a downturn is likely to arrive in the foreseeable future; the acquisition strategies of major players in the sector and/or consolidation patterns that may be emerging; changes in technology or market conditions; the state of the economy and, in particular, the stage of the economic cycle; recent or impending legislation affecting the business; or the strength of M&A market and the Stock Market. It is important that you not be coy about the reasons for sale. It will usually be one of the first questions asked by a potential purchaser and a reluctance to answer the question may make the purchaser suspicious. Source: AMDATA
7 12 SELLING A BUSINESS: A STRATEGY FOR SUCCESS MAKING A DECISION TO SELL AND TIMING THE SALE 13 The table demonstrates the following key features of the UK M&A market: there is a reasonably strong nexus between the strength of the economy and the strength of the M&A market as the collapse in the value and volume of deals in 2008 and 2009 amply demonstrates. Confidence is key to M&A activity. So too is the availability of acquisition finance for purchasers which tends to deteriorate during economic downturns; and while there is (not surprisingly) a strong correlation between value and volume of deals, it can be seen that aggregate deal value is more volatile than deal volumes. In a downturn in the M&A market the bigger deals tend to be the first casualty. At the smaller deal end of the market, there will always be a solid base of deals involving retirement sales, disposals of noncore businesses and forced sales. Apart from deal volumes, the other key indicator of market conditions is the earnings multiples being paid for private companies. This variable is measured by the Private Company Price Index (PCPI) which is shown in the table below. This shows the trend in the average price earnings ratio paid on private company sales on a quarter by quarter basis. The PCPI is shown together with the equivalent index for publicity quoted companies in the UK and the Private Equity Price Index (PEPI) which shows the average price paid on acquisitions involving private equity funding. Private Company Price Index Source: BDO Stoy Hayward There are a number of points to note regarding the PCPI. as one would expect, there is a strong correlation between demand for private companies (as measured by deal volumes) and average profit multiples being paid on private company sales; historically the PCPI has shown private companies changing hands at a discount relative to quoted company equivalents of some 35% to 40%. In the past, this has been justified by reference to the illiquid nature of shares in a private company relative to shares in publicly quoted companies. This discount has narrowed in recent years largely attributable to the spike in the Private Equity Price Index, reflecting the heady, bank debt fuelled multiples being paid on big ticket MBOs (many of which have since unravelled!). During the first half of 2009, the PCPI actually exceeded the quoted company price index, something which has never been witnessed previously; it is important to note, however, that the PCPI overstates earnings multiples on private company deals since, for the purposes of computing the PCPI: 1. potential earn-outs are deemed to have been achieved in full regardless of the actual outcome; 2. earnings figures are taken from target companies latest available audited accounts. These figures are likely to understate the underlying profits of the companies due to the inclusion of costs of a proprietorial nature which artificially depress earnings and measures taken by proprietors to reduce tax; and 3. the index does not incorporate the very small transactions which are not reported. As explained below, these deals typically involve a lower price earnings ratio than bigger deals, so, if included, would bring the average down. It should also be remembered that the PCPI is an average only and there is of course a significant disparity in earning multiples paid as between different sectors. Even in a general downturn, there are some sectors where companies change hands at attractive multiples reflecting micro-economic factors. In sympathy with the plunge in stock market multiples, the PCPI hit a six year low towards the end of 2008 and continued to trend downwards in the early part of It has since shown signs of recovery in line with the bounce in the stock market.
8 14 SELLING A BUSINESS: A STRATEGY FOR SUCCESS MAKING A DECISION TO SELL AND TIMING THE SALE 15 Valuation bubbles If there is a valuation bubble in your sector, characterised by exceptionally high profit or sales multiples, you should consider a sale of your company even if you had not otherwise planned on selling at that stage. Valuation bubbles can come about for a number of reasons such as frenetic M&A activity reflecting a consolidation play by one or two market leaders or as with the dot come bubble, a general (albeit irrational) acceptance of a new valuation paradigm for a particular sector. Valuation bubbles (such as the ultimately ill-fated dotcom bubble and, more recently, the nursing home valuation bubble) inevitably burst. Accordingly, even if your company s profits grow strongly thereafter, you may not achieve the same valuation for many years, if ever, if you miss the boat. While it is perfectly acceptable to target a particular year for a possible sale or indeed the attainment of a particular level of sales or profits, you need to retain the flexibility to alter your plans if market conditions make it sensible to do so. Critical mass As your company grows in size, not only does it become more valuable by virtue of its growing revenue/profit stream but it will also be accorded a higher valuation multiple. This phenomenon is demonstrated by the diagram below which shows that, on average, the price earnings ratio paid on company sales increases the bigger the deal size. The relationship can be explained by two factors. First, as companies get bigger, more purchasers come into play. Typically there is significantly less interest from UK acquirers (particularly private equity houses) in a company worth 5m compared to one valued at 50m. The same applies in the case of overseas trade buyers which tend to focus on businesses which have achieved critical mass. Secondly, in general, the bigger the company, the better its risk profile and earnings quality. As companies grow in size, they will typically: Trading history and projections A purchaser will find a three year track record of revenue and profit growth much more convincing than a three year forecast. It is therefore important to have a good financial track record to show potential purchasers. Equally, (though it may involve some none too easy crystal ball gazing) it is important that you sell at a time when your business is still on an upward growth curve and when you can convince a purchaser that the business still has solid growth prospects. Selling a company whose turnover or profits are flat lining or, worse still, declining is difficult and even if the company can be sold it will attract a much lower profit multiple than a growing business. The adage leave something on the table for the next owner certainly applies in the case of company sales. have less dependence on one or two key members of the management team and attract better quality management; have a better spread of customers; and be less vulnerable to attack from competitors.
9 16 SELLING A BUSINESS: A STRATEGY FOR SUCCESS MAKING A DECISION TO SELL AND TIMING THE SALE 17 Financial year end Planning a sale exercise to complete shortly after a financial year end will allow the sale to be based on an audited set of accounts. This will reduce uncertainty over the profits on which the purchase price is based and the assets being sold. Furthermore, it means that you can provide financial warranties to the purchaser based on a recently audited set of accounts. A further advantage is that due diligence by the purchaser s accountants can take place simultaneously with the year end audit, thereby minimising disruption to the business and helping to maintain confidentiality. Lastly, some purchasers may wish to have an input into the finalisation of the accounts, for example, by creating provisions for release in future periods to enhance the profits of the company in the period following the sale. Tax reliefs The current tax regime is always a relevant consideration in timing a disposal. This can be seen from the surge in company sales precipitated by the withdrawal of CGT taper relief in April In maximising value, the important number is not the headline purchase price but how much is left after the Inland Revenue has extracted its share of the proceeds. Tax planning is therefore an important element of every sale process and should be addressed well in advance of a sale exercise. Avoiding forced sales The one overriding rule in timing the sale of a business is to sell (if possible) at a time when there is no absolute need to do so. Buyers will quickly sense a forced sale and use that knowledge to their advantage. History is littered with examples of proprietors who left it too late having often been in denial of the need for a sale. If you sell at a time when there is no absolute imperative to do so, you retain the flexibility to terminate the sale process if your objectives are not being met. Regrettably there will be certain situations however (such as ill health or financial problems) which may mean a proprietor has no choice other than to put his company on the market. Time scale Determining the optimal time to start a sale exercise will be influenced by the following timetable for a typical sale process which can be used as a rough guide. The timetable also shows the demands on management time which a sale exercise will impose. On average, a sale exercise can be expected to take around six to seven months. However, this is only a rough guide. It can take considerably longer but will rarely be significantly shorter, save in the case of a distressed sale or a rifle shot exercise involving only one purchaser. In the case of a retirement sale, you must bear in mind not only the time required to complete a sale but also the fact that most purchasers will want you to remain with the business in some capacity for at least a year and possibly two post sale. Conclusion The decision to sell your company is not one which should be taken lightly. The exercise will involve an enormous commitment of management time which can impact adversely on the company s performance. In addition, an unwanted leak that the company is looking for a buyer can cause serious harm and disruption to the business. A sale exercise should only ever be undertaken if there is a strong likelihood that it will achieve your objectives and if it is the right time to sell.
10 PREPARING A BUSINESS FOR SALE 19 Chapter 2 Preparing a business for sale this gives rise attract potential entrants to your market in ensuing years, this will not be your problem (in the absence of a long earn-out). Case Study : Coopers Walking Sticks It will never be possible to maximise the valuation achieved on a sale of your company unless considerable time is taken before the sale commences to prepare your business for sale. A grooming exercise can take place over a few months or even years before a sale exercise and aims to enhance the attractiveness and value of your business to potential purchasers. This is achieved by measures such as: identifying potential purchasers early and positioning the company to attract them; raising the public profile of the company; maximising recurring profits by reducing or stopping non-recurring costs including any proprietorial or non-business expenses; improving margins through cost saving measures; and eliminating excess working capital from the balance sheet. A review of the business to determine appropriate pre-sale grooming measures should cover the following areas: Financial Matters Pricing review Even where a company enjoys a degree of pricing power, it may choose not to fully exploit that power. Generally, the pricing policy of a company is designed to maximise long term rather than short term profits. This may involve keeping prices sufficiently low to deter potential market entrants. However, in the context of a sale exercise, consideration should be given to enhancing margins by increasing prices in the lead up to the sale to improve your bottom line. If the fat profit margins to which Coopers have been making walking sticks in Surrey for the best part of 150 years. At the time of the sale, the company enjoyed a virtual monopoly in the supply of walking sticks to the NHS. The company had a very low cost base with all its capital equipment having been fully depreciated many years previously, enabling it to price its walking sticks extremely competitively. With demand for Cooper walking sticks being very price inelastic in the short to medium term, there was clear scope to increase prices and profit margins. The owner had historically been reluctant to take this step for fear of attracting new entrants into the market, however, on our advice, in the lead up to the sale, he raised his prices appreciably and in so doing significantly boosted the company s bottom line and subsequent valuation. The price rise may well, in time, have attracted new competitors but by that time the owner would have long since exited the business. Review of costs A review should be undertaken to identify and eliminate all proprietorial costs which would not be incurred by an incoming purchaser. These include relatives on the payroll, excessive travel and entertainment costs and remuneration which exceeds accepted market norms. Whilst a purchaser might be persuaded that these costs should be added back to determine the company s underlying profit, the argument is always stronger if the business can be run for a period with these costs removed. Over and above elimination of proprietorial costs, every element of the company s cost base should be scrutinized. If your business will attract a multiple of say 8 time s earnings, every 1 of cost savings achieves an 8 fold return in the form of a higher purchase price. It is not just the quantum of costs which should be reviewed but also their impact. You may for example seek to ensure that expenditure on advertising, business development and R&D is designed to produce shorter term results to help achieve a higher valuation rather than long term results which may not.
11 20 SELLING A BUSINESS: A STRATEGY FOR SUCCESS PREPARING A BUSINESS FOR SALE 21 Review of assets When a business has assets which may not be required or fully valued by a purchaser, such as surplus property or investments, removal before a sale exercise commences is recommended. In addition, in the lead up to a sale, working capital should be reduced to the minimum level required to run the business. Policies concerning stock holding levels, debtors and creditors should therefore be reviewed at an early stage to ensure that there is no fat in working capital. If the company is sold with excess inventory levels or, due to poor credit collection, excess levels of debtors, the vendor is, in effect, gifting the excess working capital to the purchaser. Any surplus working capital should be eliminated well in advance of a sale and the resultant cash proceeds either stripped out of the company or preferably added to the purchase price. Any hidden or undervalued assets of the business should also be identified. If the value of property assets is understated in the company s balance sheet relative to their market value, they should be re-valued independently prior to a sale. If your company owns the property or properties from which the business is conducted, you may achieve a higher overall valuation by either selling the property to an institutional property investor prior to the sale and leasing it back on acquiring the property from the company at the time of the sale and leasing it back to the new owner. By way of example, it the freehold property from which the business operates is worth 2m with an arms length rent of 140,000 and the purchaser is paying 6 x EBIT for your business, removing the property at the time of sale should add over 1m to the value you achieve from the sale. In all likelihood, the purchaser will reduce the purchase price by some 840,000, that is 6 x the reduction in profit resulting from the property being extracted, but you have obtained an asset worth 2m with an attractive rental income from a good quality tenant. Tax review All PAYE, VAT and corporate tax matters should be up to date and tax computations agreed with the Inland Revenue. Any tax losses available to be carried forward or corporation tax benefits from an Enterprise Management Incentive Scheme should be identified so that value can be obtained for them from a purchaser. Pension schemes Final salary schemes can be very problematic in the context of a sale exercise due to the associated valuation issues. Subject to any regulatory constraints and the rules governing the schemes, a final salary scheme should therefore be closed to new members immediately and if possible commuted into a defined contribution or personal pension scheme. Accounting policies With a sale exercise in mind, a review should be undertaken of the following accounting policies to maximise stated earnings and balance sheet values: recognition of profit, particularly for contract related businesses; depreciation policies, both for tangible and intangible assets they may be overly aggressive with a resultant depression of profits and asset values; provisions making excessive provisions against stock or debtors is one of the most commonly used techniques to reduce tax. In the lead up to a sale, excess provisions should be released to boost both profits and asset values, preferably over more than one accounting period; valuations of properties and intangible assets; and research and development this may play a large part in the purchaser s interest in the business. Small companies are frequently bought for their innovative skills and product development capabilities. Where all research and development has been written off in the past through the profit and loss account rather than capitalised, this should be identified and highlighted. As with excessive proprietorial drawings and one off items, it is possible to adjust stated profits in the information memorandum to show the impact of using more conventional accounting policies However, purchasers are always suspicious of add backs and in the context of sale exercise it is preferable to show the highest profit figure possible in the company s audited accounts. Even if this involves paying some additional corporation tax, it should be more than compensated by the increase in the purchase price which you will achieve. It is important to avoid the temptation to adopt overly-aggressive policies which might lead a purchaser to adjust the company s profits downwards in due diligence. Accounting systems It is essential for you to have high quality monthly management accounts and have in place good management information systems which track Key Performance Indicators (KPIs) and which produce timely reports on key variables. During a sale
12 22 SELLING A BUSINESS: A STRATEGY FOR SUCCESS PREPARING A BUSINESS FOR SALE 23 process, it is vital to have up to date, high quality information on the current trading performance of your company and the purchaser will be looking for you to warrant a recent set of management accounts. It is equally important that you produce high quality budgets. At a minimum, a purchaser will be looking for profit projections for both the current and the following financial year. In the case of financial buyers, a three year financial plan with detailed supporting assumptions will be required. If your company has not had a history of producing detailed budgets (and hopefully beating them) any projections produced specifically for a sale exercise may lack credibility. Operational matters Management review The quality of your management team will generally be of paramount importance to a purchaser, especially where you are proposing to leave the business at the time of, or shortly after, a sale. It is important to be able to demonstrate to the purchaser that there is competent second tier management available to assume executive control of the business following a sale. This will involve you devolving management control in the lead up to a sale. Where second line management is taking executive decisions, this should be documented. For evidentiary purposes, it may help to recognise their input formally by: minuting management meetings; issuing formal job descriptions; and promoting senior management to the Board. It might also be advisable for you to take an extended holiday before the sale to show the purchaser that the business can operate effectively in your absence. It is real danger sign for a purchaser if you have rarely taken holidays as this may indicate that you make all important decisions within the business and have no confidence in your management team. For the same reasons, it is a danger sign if the vendor is the only director. Case study : Garston Tanning Garston Tanning was one of the UK s oldest leather tanning operations. It occupied a site in Liverpool from which tanning activities had been conducted since the 11th Century. The proprietor was in his seventies and while he had two sons in the business, the fear was that given his passion for and commitment to the business, as and when he departed the scene, the performance of the business would suffer. The proprietor rarely took extended holidays but in the lead up to the sale he was hospitalised for a hip replacement operation. In the period of his absence, we were able to demonstrate to potential purchasers that the performance of the business actually improved, dispelling fears that a purchaser might have had about over-reliance on the proprietor. In the absence of his enforced hospitalisation, we would have recommended that the proprietor take an extended holiday to prove the same point. Case study : Braitrim Braitrim was Europe s leading supplier of coat hangers. The company designed the hangers, and then convinced clothing retailers such as M&S to instruct their supplier base to purchase Braitrim hangers exclusively. The company s owner/ceo was a charismatic figure and an inspirational leader. The purchaser was concerned that as and when the owner left the company, he might take the heart and soul of the business with him. We had assured the purchaser that the owner was no longer key to the business, had transferred key customer and supplier relationships to senior management, spent less than 50% of his time in the business and was actually holding the business back due to a loss of interest. The purchaser, asked us to verify these claims by providing a copy of the owner s diary for the previous 12 months. This was an excellent piece of due diligence underestimating the importance of the owner-manager to the business is one of the main reasons why acquisitions of owner-managed businesses fail. In Braitrim s case, however, the proprietor had done an excellent job of devolving responsibility to a strong senior management team in the lead up to the sale and this was verified by the purchaser s due diligence.
13 24 SELLING A BUSINESS: A STRATEGY FOR SUCCESS PREPARING A BUSINESS FOR SALE 25 Quality Marks: Non-execs and professional advisers The appointment of an experienced non-executive director or chairman can assist a company in a number of ways. Apart from assisting in the strategic development of the company through his business acumen and contact base, it is likely that the nonexec will have been involved in several sale processes and can help guide you through what is for you a novel and stressful experience. Also, if a highly regarded industry figure accepts your offer of a non-executive directorship, this gives the company significant credibility as a person of such standing will not accept your offer unless he believes the company is of high quality and has strong growth prospects. From a credibility perspective, it also helps if the company has high quality auditors and professional advisers on board. Purchasers will regard this as a marque of quality. In the case of auditors, purchasers will accord significantly more credibility to accounts which have been audited by a well known firm of auditors as opposed to a two man practice. Legal review In the lead up to a sale, you should consider conducting a legal audit in conjunction with the company s legal advisers which should, at a minimum, ensure that: trading contracts are examined to ensure that no change of control restrictions or provisions applies. Provisions in key contracts which allow the other party to terminate the contract on a sale are potential poison pills for a purchaser as the contracts in question may have considerable value. To the extent possible these provisions should be resisted; intellectual property rights are properly registered. For high tech companies, deficiencies in patent or other IP registrations can have a major negative valuation impact and sometimes deter purchasers altogether especially where a third party has challenged the validity of an important element of the company s IP. Where overseas expansion forms a key part of the company s growth story, it significantly adds to credibility if the you have gone to the trouble and expense of registering IP rights in the territories targeted for expansion; shareholder agreements and the company s articles of association are examined to review provisions relating to a sale; where possible, any outstanding litigation is cleared up. Even if it may be covered by the company s existing insurance, major litigation can be a deterrent to a purchaser. If it cannot be cleared up and is not covered by insurance, litigation insurance might be considered to remove it as an issue on a sale; to the extent possible, the ownership structure of the company is simplified. This may involve buying in minority or joint venture interests. Purchasers value simplicity and complex ownership structures can diminish the attractiveness of a business; all leases, title deeds, share certificates and key contracts are located and reviewed; and any issues relating to the ownership of the company s assets including IP rights are resolved. Positioning Well before a sale exercise is undertaken, you should identify the purchasers or categories of purchaser most likely to be interested in acquiring your business and position the business as an attractive acquisition target for those purchasers. A classic example of positioning of this variety was the sale of Seattle Coffee Company. The owners of Seattle realised that Starbucks, the US market leader, would wish to enter the UK market in the near future. In order to make the acquisition of Seattle the logical means to achieve this objective, Seattle was established as a carbon copy of Starbucks operation in the US in terms of both store locations and the look and feel of the stores. Inevitably, Starbucks purchased Seattle for a premium valuation to kick start its UK expansion. Once prospective purchasers have been identified, they should be actively courted and encouraged to take an interest in the company. This might involve visiting potential overseas acquirers to discuss strategic alliances or making oneself an irritant to competitors by aggressively targeting their customers to motivate them to acquire you. Corporate strategy Before making any strategic decisions, you need to assess whether the decision would enhance or detract from value from a purchaser s perspective. This ranges from the
14 26 SELLING A BUSINESS: A STRATEGY FOR SUCCESS PREPARING A BUSINESS FOR SALE 27 blindingly obvious such as not renewing a 20 year lease on the company s premises just prior to a sale (as this might represent a poison pill for a purchaser who wants to consolidate the company s operations with its own) to more subtle positioning type issues such as whether diversifying the business into related activities will make the company more or less saleable. Case study : Dial-a-Phone Dial-a-Phone is the UK s leading direct seller of mobile phones. It has sold over three million phones since inception in One of the keys to the company s success was its call centre which took the orders for the phones and made outbound marketing calls. In the lead up to the sale, the proprietors sought our advice on the possibility of utilising the call centre to sell other goods or services. Indeed, the company had gone as far as registering the trading name Dial-a-Loan with a view to starting a loan broking business. Our advice was emphatic don t do it for the following reasons: the venture would make start up losses and it would be difficult to get full value for the potential future profits of the venture; the venture would have distracted management s attention away from the core business at a critical time in the lead up to the sale of the company; and most significantly, we were intending to market the company as a telecoms business. Telecoms companies were, at the time, trading on relatively attractive profit multiples. The moment the company sold anything other than a telephone from its call centre, it immediately became just another direct seller. Direct sellers, at the time, were trading on much lower multiples than telecoms businesses. Environmental audit Potential environmental liabilities will be a major area of concern for any purchaser. Depending on the nature of the business, it may be appropriate to commission a specialist environmental consultancy to conduct a desktop environmental audit or (in the case of premises with potentially significant environmental issues) a full environmental audit including ground testing prior to the sale to enable any potential problems to be identified and remedied at an early stage. Environmental issues coming to light at a late stage have the capacity to derail a sale exercise. Data room Gathering information for a data room at an early stage can significantly truncate the subsequent sale exercise and is an essential component of the information disclosure process. Data rooms are dealt with in more detail in Chapter 9. Vendor due diligence Vendor due diligence involves you instructing a reputable firm of accountants to prepare a due diligence report on your business in advance of a sale exercise being undertaken. The report is then given to potential purchasers who have expressed serious interest in the company for use in finalising their offers. The purpose of vendor due diligence is to flush out financial, tax, operational and other issues relating to the business at the outset of the sale process and in conjunction with the data room, to ensure that final bids are based on all price sensitive information. If this objective is achieved, the chances of the deal collapsing or the purchase price being reduced once heads of agreement have been signed and a preferred bidder chosen, are significantly reduced. It is unlikely that any material financial issues will arise from the purchaser s due diligence which had not already been identified in the report if that report has been prepared diligently. In addition, vendor due diligence can form a useful part of the grooming process to the extent that it identifies issues which can be addressed before the sale exercise is initiated. In choosing an accountant to produce a vendor due diligence report, it is advisable to appoint a top tier accounting firm. If this rule is ignored, a purchaser is less likely to use another firm of accountants to conduct final due diligence rather than adopt and update the vendor due diligence report after being confirmed as preferred bidder. Adoption of the report by the purchaser is a key objective of the vendor due diligence process as introduction of another firm of accountants will have timing implications and leave you vulnerable to the new accountants taking a different view on certain financial issues or the validity of your financial projections.
15 28 SELLING A BUSINESS: A STRATEGY FOR SUCCESS In addition, you should avoid the temptation to use the company s auditors to prepare the report. This will impact adversely on the credibility of the report. A purchaser will inevitably have some suspicions that the auditor has been leant on to provide a favourable report and will almost inevitably therefore not adopt it. Commissioning a vendor due diligence report is a costly exercise so a decision to do so should not be taken lightly. Also, the terms of reference for the report need to be highly focussed. Accountants will often offer costly elements of a report (such as management profiling) which are not required. Conclusion The more prepared the business is prior to the commencement of the sale process, the greater will be the ultimate valuation achieved. However, it is important for you not to groom your business for sale in an over-zealous fashion or attempt to boost profits in artificial ways which will be exposed during due diligence. This will backfire on you and may destroy a relationship of trust established between yourself and the ultimate purchaser. It is also necessary to commence the grooming process long before the sale process gets underway. The impact of steps taken to enhance profits, for example, will take some time to flow through to the company s accounts. Chapter 3 Appointing advisers On a typical sale exercise, you will need to engage the services of: a financial adviser; a lawyer; a tax adviser; and a wealth management adviser. Occasionally a PR consultant will also be engaged. This chapter sets out the process which you should adopt In selecting and engaging advisers. Why appoint a financial adviser? There are a number of reasons why it is preferable for you to engage the services of a professional adviser to sell your business rather than adopt a DIY approach. These include the ability of financial advisers to maintain confidentiality, their superior knowledge of and access to potential purchasers and their negotiation skills. By way of example, although you are likely to have a good idea of the potential UK trade buyers for your business, your adviser is likely to have superior knowledge of financial purchasers, potential overseas acquirers and purchasers outside your own sector. It is also useful to have an intermediary negotiating the sale of your company. Not only are they professional negotiators in the context of company sales, but an advisor can adopt a tough negotiating stance to secure the best possible deal and allow you to be removed from the fray. This enables you to maintain a good working relationship with the purchaser which is important, especially in situations where you are remaining with the business post sale. A good financial adviser should be able to add value to the transaction many times the amount of his fees.
16 30 SELLING A BUSINESS: A STRATEGY FOR SUCCESS APPOINTING ADVISERS 31 Role of the financial adviser The role of your financial adviser is to: advise on appropriate measures to groom your business for sale; advise on timing and provide an indicative valuation; prepare the sale documentation including the information memorandum; identify and approach potential purchasers; lead negotiations with potential purchasers; advise on the offers received and the appropriate structure of a sale; manage the due diligence and legal phase of the transaction (in conjunction with your legal advisers); and ensure that the transaction is completed on a timely basis. Types of financial advisers Some advisers merely act as introductory brokers while others provide a full advisory service. The main categories of M&A advisers are as follows: Investment banks Investment banks tend to focus on larger transactions. It is extremely important that your business does not represent a small transaction for your adviser as this will be reflected in the level of service which you receive including the level of director or partner involvement. Large investment backs will therefore not represent the preferred alternative if your business is worth less than 100m. Accounting firms In volume terms, the big four accounting firms are among the largest players in the UK M&A advisory market. However, before appointing an accounting practice to act as an adviser, you need to be satisfied that the firm does not have any conflicts of interest. Such conflicts can arise if one or more of the likely potential purchasers is an audit client or alternatively has been retained by the accounting firm on either an acquisition brief or to provide corporate finance or other consultancy advice. You should also check if the accountants are allowed to approach potential purchasers in the US, where there are restrictions on accountants providing M&A advisory services. Accounting firms may offer an apparently attractive all-in package of taxation, vendor due diligence, corporate finance advice and occasionally legal services. Whilst this may have the potential to save money, you should take care to consider whether you really need all these services. Also the provision of such an integrated service may well involve conflicts of interest between the constituent elements. Boutiques There are a number of M&A boutiques which are either generalist M&A advisers or focus on particular industry sectors such as financial services or retail. Care needs to be taken before appointing a boutique adviser to ensure they have adequate resources to provide a comprehensive service. One or two man operations are unlikely to meet this criterion. As with the accounting firms, care should be taken to ensure that the boutique does not have an excessively close relationship with a particular purchaser or purchasers which could raise questions about their ability to act in your best interests. Also, before appointing an M&A boutique, you must establish that it has sufficient professional indemnity insurance cover, is FSA authorised and has a good international network to source overseas buyers. In terms of sector experts, while they may have a very comprehensive knowledge of their chosen sector, they may be too blinkered to identify potential acquirers outside your sector. Such lateral thinking is an essential component of the potential purchaser identification process. Choosing a financial adviser The personal chemistry that must exist between you and your adviser should not be underestimated. Frequently, a sale exercise will involve stressful negotiations with the need to make important decisions quickly. It is important that a cohesive team is presented to a purchaser. In choosing an appropriate financial adviser, you should also have regard to the following considerations: make sure that your deal will be an important one for the adviser. You are much better off being at the top end rather than at the bottom of the adviser s typical deal size spectrum; conduct a beauty parade of two or three potential advisers, preferably from different types of organisations;
17 32 SELLING A BUSINESS: A STRATEGY FOR SUCCESS APPOINTING ADVISERS 33 ensure an adviser has relevant experience in the type of transaction envisaged; always insist on both references and fee quotes. When obtaining a reference always check who actually did the work. Was it the silver tongued partner you have just met, or the inexperienced new recruit? make sure the appointed adviser has a good overseas network to identify overseas buyers; beware of false economy. Don t allow fees to be the main determinant of your choice of adviser. There is often a reason why one adviser can consistently charge higher fees than its competitors; ensure that an adviser will not face any conflicts of interest if appointed; ascertain who will be working on the transaction on a day to day basis; ensure the adviser is properly authorised under the Financial Services Act, and has adequate professional indemnity insurance; and bring a financial adviser on board well before the sale process actually gets under way. The preparation of your business for sale is of equal importance as the sale process itself. Basis of fees Most advisers charge an initial retainer and then a success fee based on the purchase price achieved for the business. Typically success fees will be in the range of 1-3% depending on the size of the deal. Most fee structures contain a fixed minimum success fee plus a ratchet whereby the percentage fee increases if the purchase price exceeds a level which you agree with the adviser represents a reasonable target valuation. This ensures that the adviser is incentivised to achieve the highest price for your business. Care should be taken in fee negotiations with advisers to ensure that: the concept of consideration is fully understood by both parties. Does it include for example, pre-sale dividends and the assumption of any financial debt by the purchaser? the circumstances in which any abort fees apply are fully understood; the adviser is not going to seek a fee from a purchaser. It is not in your interests that your adviser may be seeking fees from purchasers as it will compromise the adviser s negotiating position, particularly as some purchasers will never pay fees and thus may not be contacted by the adviser; and the adviser is not incentivised to push a transaction towards or away from certain purchasers. This typically happens where a business has had an approach before the adviser is appointed and where the fee arrangements are very favourably skewed towards alternative buyers. Consequently, the adviser may spend huge amounts of time on new buyers and neglect the existing bidder. Appointing legal advisers Top tips for appointing advisers ask for unrestricted references an adviser should be happy for you to take references from any former client; meet the entire deal team including the workers as well as the front line partners or directors; ask all potential advisers to sign a confidentiality undertaking up front which prohibits them from talking to buyers without your prior permission. This prevents an adviser who is not ultimately appointed by you obtaining a buy-side advisory mandate for the business from one of the most obvious buyers and then making an approach on their behalf before the sale process kicks off this can completely derail a carefully orchestrated sale process; be careful not to be seduced by advisers who provide excessive valuations of the business (which they know they can t deliver) just to win the sale mandate; beware of organisations which appear excessively busy or conversely have little work; and you should not be pressurised to put your business on the market immediately, without any real justification. Advisers make their money from selling businesses but they should also be prepared to take a long term view and give impartial advice. Legal advisers are not a commodity. A good lawyer with commercial flair can add significant value to a transaction, not only in terms of the quality of his legal advice,
18 34 SELLING A BUSINESS: A STRATEGY FOR SUCCESS APPOINTING ADVISERS 35 but also in ensuring that the deal completes in a timely manner with as little acrimony between the parties as possible. The following guidelines should be followed when choosing a lawyer to advise on the sale of your business: ensure that the lawyer is an M&A specialist with appropriate experience of similar transactions. Do not be tempted to appoint the family lawyer who may be either a generalist or, worse still, a specialist property lawyer; make sure that the chosen law firm has sufficient resources to properly service an M&A transaction. The chosen law firm should have expertise in all relevant practice areas which could include tax, property, intellectual property, pensions and employment law as well as corporate finance. In the latter stages of the transaction, the lawyers will need to provide a round the clock service. Be wary of a law firm whose answering machine comes on at 5:30pm; do not underestimate the importance of having a good personal relationship with your lawyer; conduct a beauty parade involving two or three suitably qualified law firms; insist that the partner who attends the presentation is present at all key negotiating meetings; if the transaction has an international aspect, ensure that the law firm has a good network of overseas offices; ensure that the law firm has adequate professional indemnity insurance; get fee quotes up front. There are a number of different fee arrangements including: 1. conventional time costs; 2. time costs with a cap; and 3. glad or sad type arrangements which may include a fee uplift for a successful deal and a reduced fee for an aborted transaction. There are advantages and disadvantages to each type of arrangement. Your financial adviser should be able to advise you on the most suitable arrangement for your situation. Appointing tax advisers Capital gains tax mitigation is an important element of any sale process. In order to achieve that objective, the key is to appoint a specialist adviser who has considerable experience in advising vendors of private companies. The alternatives include the law firm retained to advise on the sale, a firm of accountants or a firm of specialist tax advisers. It is always useful to get second opinions on any tax planning proposed. Overly aggressive tax planning involving high risk tax schemes should be avoided. You have taken sufficient risks in creating a valuable business. Excessive risk taking in the context of a sale process should be avoided. Wealth management advisers After you have sold your company you are faced with the sometimes daunting task of investing your sale proceeds. Most vendors (very wisely) will engage the services of a professional wealth management adviser who will assist them in devising an investment strategy to meet their objectives. Interestingly most vendors adopt very conservative investment strategies. They quite rightly take the view that they have taken significant risk in creating the value they have realised from their business and their emphasis post sale is therefore on capital preservation. If you are looking to engage a wealth manager, it is best to beauty parade two or three different advisers and select the one with whom you have the best chemistry and whom you are confident can assist you to meet your investment objectives. Conclusion Getting good advisers on board well before a sale process actually kicks off is a prerequisite for maximizing the ultimate proceeds of sale. The relationship with your financial adviser may endure for several years so apart from ensuring that the adviser is best placed to help you achieve your objectives, personal chemistry is of paramount importance.
19 VALUATION 37 Chapter 4 Valuation The actual valuation of a business will ultimately be dictated by the price which a willing buyer is prepared to pay for it. However, while valuing a company in advance of a sale is not an exact science, the following factors are key in determining your company s value: the company s historic and projected financial performance; the attractiveness of the sector in which your company operates and the strength of its market position; the size of the company; the strength of its management team; and the company s asset base. Methods of valuation Although there are a number of methods used for valuing a company, the following two methodologies are most frequently utilised by acquirers: multiple of normalised earnings (typically favoured by trade buyers); and discounted cash flows (used by financial buyers). Multiple of normalised earnings This valuation methodology applies an appropriate multiple to the normalised earnings of a company to convert those earnings into a capital value. Normalised earnings are a company s reported profits adjusted for any abnormal or nonrecurring items. Once the normalised earnings of the company have been determined, the appropriate multiple to apply to these earnings is determined by reference to: the earnings multiples on which comparable quoted companies are trading on the stock market; and the earnings multiples on which similar businesses in the company s sector have recently been sold. On average, UK private companies are sold at a discount to quoted public company profit multiples though, as shown in Chapter 2, the level of this discount has reduced in recent years. Any discount applied to comparable quoted company multiples should be adjusted by reference to factors such as the growth profile, market share and size of the company. Let us take, for example, the case of a pharmaceutical business which, for its last financial year made an operating profit of 2m before interest and tax. The owner took out of the business in salary and pension contributions around 500,000 in excess of an arms length level which would have been required to be paid to an external candidate for the CEO role. In addition, there was some 500,000 of costs which could properly be categorised as one-offs which would not recur under the ownership of a purchaser. These included costs involved in fighting a substantial piece of litigation and an exceptional loss on the sale of a property owned by the company. Accordingly, the company s normalised operating profits for its last financial year were 3m. An analysis of recent transactions in the company s sector reveals that a competitor of a similar size and growth profile had been sold recently for an historic multiple of earnings before interest and tax ( EBIT ) of 8 times. This comparable transaction would support an enterprise value (that is excluding any surplus cash or borrowings) for the company in the region of 24m. However, the company has a term loan of 2m and a fully utilised invoice discounting facility of a further 2m. A purchaser will always deduct any borrowings from the price he pays for the company. Accordingly 4m (assuming the company has no surplus cash) needs to be deducted from the 24m enterprise value to obtain an equity value (the price the vendor will receive for his shares) of approximately 20m. Earning before interest and tax (EBIT) 2m Add backs to profit 1m Adjusted EBIT 3m x 8 24m Less Borrowings 4m Equity Value 20m
20 38 SELLING A BUSINESS: A STRATEGY FOR SUCCESS VALUATION 39 Discounted cash flow ( DCF ) methodology The discounted cash flow methodology values a business by discounting the projected future cash flows which an acquisition of the business will generate to ascertain their present value. From the perspective of a private equity house investing in an acquisition of a company, these cash flows will comprise any running yield/dividends or capital repayments it receives during the life of the investment plus the exit value of its investment, being the proceeds of an ultimate sale or flotation. Private equity houses have a minimum internal rate of return ( IRR ) which they will seek (traditionally circa 25%) on any equity investment they make. From their perspective, the maximum price they will be prepared to pay for a company is the price which results in it achieving its hurdle rate of return. At this price, the value of its initial investment will be exactly matched by the positive cash flows it expects to generate from the investment, discounted by its minimum IRR. Care should always be taken with any DCF valuation methodology as the resultant valuation is heavily dependent on the company s financial projections. Even small changes to the discount rate and the assumptions on which the projected cash flows are based can have a material effect on the valuation. As with all valuations reliant on projections, the result is only as good as the quality of the assumptions which are made. While valuation models are often used in price negotiations with purchasers, as a general rule it is not advisable to provide purchasers with a target valuation up front. If the valuation is pitched too high it may frighten certain purchasers away. Too low and it will set a cap on purchasers bids which may have otherwise been exceeded. Rather, it is better to let interested parties submit bids in a competitive environment and then negotiate those offers up by reference to other bids, and with the selective use of valuation methodologies which support a higher offer. Other valuation methodologies Profits or cash flows are not always the main determinants of a company s value. There are certain sectors, such as computer software and software services where sales multiples represent the predominant valuation methodology. Fund management companies are valued as a percentage of funds under management while for companies involved in property investment, net asset value is the primary determinant of value. There are several other industries in which other specific valuation methodologies apply your adviser will be able to tell you if your business falls within them. Conclusion Valuing a company in advance of a sale is a highly theoretical exercise. One will only get a good feel for the valuation which a company is likely to achieve when conversations are initiated with purchasers and the level of interest in the business is determined. Ultimately, prices at which companies are sold, in common with all other prices, are determined by the laws of supply and demand.