Exit Planning Step Three
This is the third in our series on exit planning for you as owner-manager. In the first month we focussed on the importance of appointing a lead adviser. Last month we discussed the importance of being clear on your personal objectives and the alternatives available to you as the owner.
We now need to turn our attention to whether it would be a good idea to have your company valued in the early stages of planning your exit. Our November issue offers some thoughts on this subject.
If you know of someone you think would benefit from this blog do please forward it to them.
James Hunt and the team at Everyman Legal
The whys and wherefores of valuing a private company
You may well feel that a professional valuation for your company should be a key early step in any carefully planned exit. This is a service which your accountants may offer. If you use a larger accountancy firm they may have an adviser who has considerable experience in negotiating values with HM Revenue & Customs or in matrimonial disputes.
But beware of a valuation methodology developed with tax or estate planning in mind. Such a value may be very misleading in the context of a prospective sale. The valuer may be very skilled at persuading HMRC to agree the value you want but that may be very different to the approach a buyer would take.
HMRC may be easily led and, after all, will not have a skilled negotiator, who is very inquisitive and can analyse the positives and the negatives, on its team.
When selling a company the attribute that is likely to get you the best value is the instinct of a street trader. The first question any trader will ask when invited to give a value is, “am I buying or selling?”
There are no right and wrong answers. I remember Peter, a merger broker, with whom I once worked. His philosophy was that before you worry about the numbers and any valuation you must first address the people issues. If the people issues work and there is mutual respect between buyer and seller, a price that is fair will eventually be agreed. After all, fair-minded people will want to explore their own perspective and that of the other side, to consider the key assumptions on which any assessment of value will ultimately depend. But if you are not yet involved in a negotiation how can you get a feel for the potential range of values?
The starting point for a standard valuation
A valuation will often work as follows. The valuer will find one or more quoted companies in a comparable sector to your own and see what multiple of after-tax profits the shares of those companies trade on. That multiple will then be discounted by a factor (perhaps 60%) to reflect the fact that your company’s shares are not traded and are therefore illiquid.
The valuer will then assess the adjusted after-tax profits for your company. As you will likely have drawn profits as dividends rather than salary this will mean adding in a notional salary for someone to replace you as a manager. There may also be non-recurring (perhaps personal) expenditure to be taken off. The adjusted net profits may be averaged for the last three years.
The resultant after-tax profit figure is multiplied by the chosen multiple. To this sum will be added any investments or surplus cash not needed for working capital in your company.
A private company will typically sell on a multiple of between three to eight times these true profits.
The acid test
But is there any substance in such a desk-top valuation?
Unless and until you test the market you will never know what your company might be worth. At the end of the day your company will be worth what someone is prepared to pay for it. There may be a special buyer who for strategic reasons is prepared to pay more for your company than might be expected.
For example, a competitor may be interested in buying your company for its order book and to close down your business. But you may feel that to see you life’s work destroyed (even if it means a big cheque for you) would be abhorrent.
Is your business too dependent on you?
The “taking stock” step (see the October blog) should have revealed the sum (net of tax) that you need in order to be financially secure in your retirement. However, if your company is not yet sale-ready – often because it is too dependent on you as owner-manager – then rather than seeking valuations and wasting time and money on a sales process that will not achieve your objectives, you are likely to face a simple choice. Give yourself time to ensure that your company is performing as well as it can or sell at what you perceive to be a bargain basement price.
A buyer may walk away if he perceives that the business is too dependent on you, the owner. The first challenge for you then will be whether you have been able to create a team of managers who can run that business without you. Secondly, whether you and your managers have been able to systemise all of your processes (from product innovation, to production, to sales and finance). If you have, and if you are lucky enough to be operating in a growing market without very significant competition, then your projected profit growth may be exceptionally high.
The key to a great price for your company will be showing a good record of increasing profits and the promise of continuing steeply rising profits. In that case your prospective buyer can be expected to pay you a high multiple of your adjusted profits. They are, after all, buying their perception of the future cash flows.
Although the key to a successful sale will be showing steeply rising future profits you will almost certainly have had to build a great management team to achieve those profits.
How are you going to recruit, retain and motivate that team in the first place? You may be able to do so with share incentives (we will discuss that in a future monthly newsletter) and the potential for capital gains from those shares. But the A-team you need to build may be motivated by factors beyond riches and talk of a trade sale where jobs may be at serious risk and the culture you have created in jeopardy.
At the same time your own anxiety about selling your soul may lead you to put off the process of planning for your retirement.
Selling to your own team
Rather than selling to a third party you and your team may find it is very empowering for you to sell your company to them. When we suggest this to owners they will often respond that the managers have no money and could not afford to buy the company.
That brings us back to the vexed question of valuation and for many owner-managed companies the fact that selling your company for the price you want on a trade sale may be well-nigh impossible. So selling to your team, perhaps a strengthened team, may be your only viable route to a secure retirement.
If you follow this course a third party valuation will almost certainly not be needed. What will be needed, though, is a replacement team leader, a managing director designate. You will want to have an open dialogue, facilitated by your lead adviser, with the team led by this person.
In most deals of this sort, you as owner, will be wearing three hats after the deal: you will continue to be a manager (but with a new title and role), you will be effectively the banker to that deal and will likely keep a minority holding – so you are also an investor.
If you have selected the right MD-designate and you are looking at the future fairly and objectively then you and the team, with guidance from your lead adviser, will be the best-equipped individuals to debate these future cash flows: the valuation will naturally flow from that debate. Should the team not wish or not be capable of taking part in the debate they are almost certainly the wrong managers – or at any rate the group lacks an MD or MD designate who will take over from you as the driver of the business and the person with whom the buck stops.
Hints and Tips
- Successfully executing your retirement from the company you started will almost certainly involve building a management team under a new team leader. Through that team you will have been able to systemise the business so that it is not dependent on you;
- Creating that team will be crucially dependent on aligning the interests of owners with key managers;
- Focusing on a trade sale may be dispiriting to you and your management team. Your interests and theirs may not be aligned;
- Consider with a lead adviser what the stumbling blocks to a trade sale would likely be
- Consider whether a management buy-out may be a better plan. If it is then recognise that it may take many years to execute that plan and so start planning early;
- If you decide to sell, engage the services of a skilled merger broker who has the instincts of a trader.
Next month …
Next month we will talk about the importance of an exit audit.