To get a full price you need competition. It’s only when you get purchasers into a competitive environment that you know the real value of your business. Once purchasers are going head to head, fundamentals can get forgotten and in bull markets valuation almost becomes a ‘dark art’ as rational measures of value get forgotten in the scramble to do deals. However, in the current climate, buyers have returned to business fundamentals and are firmly focused on profits and assets.
There are any number of different valuation techniques purchasers use ranging from discounted cashflow models, asset value, multiple of sales, replacement cost and opportunity cost, but by far the most common valuation method we see for private companies is one of the oldest and most simple, the price earnings or PE ratio adjusted for surplus assets:(underlying earnings x multiple) +/- surplus assets/debt).
Most trade purchasers are looking at acquisitions as a way of improving their future earnings and as a result improving the valuation of the enlarged group. The best guide to assessing the future earnings of any prospective target is to look at their historic, current and forecast earnings. However, this may not paint a true picture, many private companies are not run to maximise profits; due to a natural reluctance to pay large amounts of tax. So when presenting financials to a buyer, adjustments need to be made to calculate the “underlying earnings”. While these adjustments are common the fewer adjustments that are made the better.
Excess staff remuneration
Packages to staff that are above market norms may be viewed as quasi-equity and adjusted. A recent client paid significant bonuses to staff in lieu of equity participation in the deal, so clearly that needs to be added back.
This can include all sorts of expenditure which is common in private companies but tends to be tolerated less in the post-Enron environment at Plcs. As well as the obvious expenses like entertaining, other real life examples include: the running costs of a team of racing cars, school fees, membership of Loch Lomond golf club, a £150,000 staff party and the overseas holiday home.
These are usually large one-off items. Whether they are actually defined as exceptional items in the audited accounts is largely irrelevant, although it certainly makes the inclusion of an item easier to justify. Unusually large bad debts, unusual professional fees, losses on discontinued or sold business divisions, losses on foreign exchange transactions or asset disposals are examples that may fit into this category.
Most purchasers tend to look at operating profits and will therefore exclude all interest payable or receivable.
Once the underlying earnings of the company have been established, this will form the basis of a purchaser’s valuation, however, further adjustments may well be needed by the buyer to account for: differing accounting policies, rates of depreciation, software amortisation amongst other things. The more transparent a vendor is in disclosing the financials the better.
Multiples used in valuation can vary enormously and are determined by a number of factors, many of which are outside the vendor’s control.
First, and foremost, multiples used in valuing private companies have a direct relationship with the value of comparable listed companies. Just ask anyone connected with PWC Consulting who saw its value drop from a mooted $18bn from HP to an eventual $3.5bn when acquired by IBM eighteen months later.
Secondly, a strategic buyer will always be prepared to pay a premium over a tactical or financial buyer, as their earnings will benefit from the deal through a combination of:
a. Cost savings – profits will be boosted by cutting costs, for instance, cutting the accounts department or closing duplicate offices or manufacturing plants.
b. Revenue synergies – companies will often make acquisitions to plug a significant product or skills gap in their portfolio, particularly overseas buyers who need to build a global network quickly and efficiently to service their international accounts.
c. Opportunity cost – the acquisition may benefit the strategic buyer in indirect ways. For example, we sold a wireless services company to a financial institution that was able to bring to market its new wireless financial product a lot earlier by deploying the acquired wireless engineers, thus justifying a premium price.
Buyers want growth, and are prepared to pay for it. As a very rough rule of thumb a listed company that can grow profits or sales at 30% annually will warrant a PE x 30 whereas one growing at 10% will only have a PE x 10. So, build a robust and compelling growth story. Selling a business at the peak of the business cycle is too late, you need to leave something on the table for the buyer. He needs to buy into your vision for growth to justify paying a premium.
A business that has a consistent record of profitability will be worth more than a one-year wonder. You need continuity to build confidence in the business model. Recurrent business, non-reliance on one customer, longer term contracts and substantial order books all reduce risk to a buyer and therefore justify a premium in the multiple.
Show commitment to the buyer to help reduce handover risk. Many deals have an earn-out or partial deferred payment to retain and incentivise management to stay. If you are an owner/manager and have a fixed date that you want to exit by, then you are better selling the company early, unless you’re not really involved with the day-to-day management.
Be flexible, every vendor wants cash, yet most purchasers want to use shares. There is usually a compromise. Recently, most of the deals we have seen in the market have actually been all (or substantially all) cash, but as equity markets recover shares will be used again. Vendors that were enticed by notionally high valued equity deals in the last bull market had their fingers burned. There is a base price for a business that clearly needs to be in cash, but taking some equity shows commitment and enthusiasm to the purchaser. An earn-out can also be a useful way of increasing value, linking future performance to returns.