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Musings on business value, sale preparation, sale negotiations, sale structure.

Archive for September, 2014

Perfectly, practical production

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I play water polo – after a fashion. It’s great to get out into the sun at the start of the season into cold water and wrestle with other wet, fat middle aged guys in speedos for half an hour or so. More fun is sitting in the pub after the game, gently teasing the opponents, sprouting political theories and watching the rugby.

So after the first match the season, I happened to listen in on somebody talking about how he had found a wonderful business where the owner puts on his overalls every day, and gets dirty on the factory floor with his workers. “And you know, because he is there, the product comes out perfectly every time. You just don’t see businesses like that anymore.”

What he was describing, is actually not a business at all. It is a job, where the owner is helped out by some guys who it seems, may be incompetent without the owner kicking butt on a regular basis.

Now there may well be a market to sell such a business to a like minded individual, but heck, that market is small, and shrinking every year. That sort of business needs an artisan to own it. Somebody else who enjoys working with his hands, and doesn’t trust his workers to get on with the job because they are badly trained, disciplined or incentivised.

With small demand, hard work expectations and jobs, rather than real businesses, come poor prices. Typically, the business can only be sold in an asset deal, and not in a much more beneficial-to-seller, equity deal. Similar buyers are always going to be around, looking for those kind of deals as they too, seek to become masters of their own destiny. But they are never going to have sufficient funds available to create a demand which drives the selling price into something really beneficial to the seller.

Ratio-nal problems

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Some call it the art of business. Others refer to it as business science. Most are confused by it. Not that anybody ever admits to being confused.

It is something that exists in any business, whether we like it or not. If a business owner uses the information, it can be a very handy tool to gain profitability and therefore, greater value. What am I referring to? Ratios inherent in almost everything you do as a business owner. The most obvious is the gross profit ratio, usually called the GP%. It is simply the gross profit of the business divided by the sales. That is a simple concept which I have covered before.

On a fairly regular basis, I am asked what the ROE on someone’s business should be, or the ROA (or any of the GP, current ratio, quick ratio, interest cover, and a whole lot of others). Here is the problem: At an academic level, there may be a “correct” theoretical level. But in a small country (with a smaller economy than some European and USA cities!) it is almost impossible to tell the owner of a pipe extrusion factory what the optimum level of any of these ratios should be, in comparison to similar businesses. The size of the sample is simply too small to make any meaningful comparisons.

It is also a smoke screen to bulldust, and a it is a con to claim to be able to compare the ratios to similar businesses from a database of millions from other countries where basics such as interest rates, infrastructures, wage demands, political imperatives and socio economic expectations are so different.

Here is an example from Guide to Analysing Companies by Bob Vause – an Economist publication:

These are the typical pre-tax profit to sales ratios for various industries (columns) in different countries (rows). Think of the numbers as percentage of sales turnover.

Country Retail Food Building Hotels Pharma
France 2.7 6.7 4.0 4.7 10.0
Germany 4.0 1.4 8.4 2.8 13.7
Italy N/A 5.1 8.2 9.4 20.7
Netherlands 5.7 1.9 9.7 7.7 18.7
UK 7.4 6.6 10.0 26.0 25.4
USA 4.2 9.6 6.4 9.3 26.8

So how does that help us?

It’s a rhetorical question, because it couldn’t possibly help us. On the other hand, look at this:

Sales turnover

This is the sales curve of one of our clients. It is rising nicely – well ahead of inflation, and should be the source of some pride. The problem was that over several years his bottom line profits were declining in Rand terms. This, despite the fact that he kept a solid lid on fixed expenses.

Some very basic ratio analysis revealed this:
Ratios of sales

Suddenly his problem is highlighted in very graphic detail. He had been chasing turnover at the cost of his gross profit ratio. With the higher turnover comes higher risk in holding more inventory, bigger debtors’ book, higher banking fees, more labour etc. Ultimately, his net profit before tax (NPBT) suffers. And that is what really counts.

As it happened, he was being bullied by his biggest customer into taking smaller and smaller margin on bigger and bigger orders, even though his only competition was on the other side of the country.

Year after year he was presented with his financial statements and told that his ratios were within industry norms. In isolation, they may well have conformed to something in a text book or an industry web site, but in reality, the norm just did not work for our client.

Happily, he is working towards lifting his GP%. His higher prices are lifting his sales turnover, and the quantity of product continues to rise, making for an even happier client. His experience in keeping overhead under control, continues to pay off. The bottom line is that over the next few years, the value of his business is likely to multiply by 5 or 6 times, based on our projections.

The point of this illustration is to show you that when someone tells you that he has the metrics of 100,000 businesses, and can guide you accordingly, you should take that information with a pinch of salt. The only reasonable comparison, in my opinion is to compare such things internally within a business to the same calculations in previous periods, and then to work towards regular, measurable improvements.

Part of our valuation process involves looking, not so much at what the ratio between two numbers is, but more importantly, and infinitely more useful, the trend of that ratio, and others which may relate to it.   You can do this at home, and it will make a lot of sense, as long as your financial statements are prepared on the same basis every year. Calculations can even be done on a monthly basis, and compared monthly, as long as you keep in mind that annual results will be different from monthly results, given the different reporting standards.

Shedding some load

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I was asked to attend a meeting of creditors with respect to the Ellerines business rescue in early August. There were hundreds of very grim faced people there, although I don’t know who was an employee and who was a general creditor, and so on. Judging by some of the questions from the floor, there are some small business people creditors, for whom this is their major, and possibly only customer.

The meeting highlighted for me the exposure small businesses tend to have in not spreading their wings to a much wider base of customers, as difficult as it is to do so. Prospective buyers of businesses are likely to be limited to industry investors in such circumstances; competitors with similar problems, looking to grow and spread their own risk through acquisition.

Unfortunately, in such circumstances, selling prices are always low. The alternative to selling is to cling on for as long as possible, and hope you don’t lose that one really big customer.

Anyway, back to Ellerines, which is reportedly shedding 500 branches this month, in order to make itself a viable entity. That is 500 fewer branches through which suppliers can expect their goods to reach the consumer.

Just another reason for you to look carefully at how many different customers you have, and which of them may be vulnerable to either becoming insolvent or moving to another supplier of whatever it is you make or supply.


Redundancy Standard – Bank on this

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One thing that is certain to give you grey hairs at some stage in your business owning life, is the concept of redundancy. If, when things hit fans, you are able to move easily to an alternative supplier or resource, you will have an edge over your competitors, and still be able to deliver to your customers. With minor glitches perhaps, you will be able to maintain your profitability, and hence your business’ value.

I maintain several prepaid SIM cards from different carriers in order to be able to buy some data quickly, in need. In the last year that policy has helped me several times as my primary operator has thrown a fit, or I have found myself at a meeting or conference with poor coverage for my principal carrier.

If your business has only one supplier of a primary service or product, your bank will take a dim view of the business value and risk profile. Particularly if that single supplier can screw up the first day of spring for you. As I originally wrote this, a Standard Bank executive was claiming that everything was back to normal. It was not. “If I can be honest with you….” (like they aren’t always). “We truly apologise… ” (because it’s not always truthful).

Why do we insist on having all our funds and facilities in one bank?

The problem stems from the banks themselves who insist on certain “covenants” if your business has any sort of credit facility with them. Some of those covenants created potential value problems for Standard Bank customers when their electronic banking facilities collapsed for the first few days of September 2014.

So the week 36 little debacle serves to highlight in an inconvenient way how we can fall foul of the very covenants which our various banks insist on, in order to safeguard them.

Try negotiate yourself into a space where you are able to have more than one supplier, including your banking supplier. Just so that if something desperately needs to be paid on the first day of spring, you are able to pay it or (better) receive it.

I have bounced this idea off several clients, friends and banks over the last two weeks. Here are the problems:

  • Your banking covenants forbid you doing so, particularly if you run any sort of credit facilities with the bank
  • There is only so much money to go round
  • You’ve already burned all your bridges at other banks
  • You just couldn’t be bothered

I don’t think any of those are insurmountable. Just do it. We are South Africans. We make plans.