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

Archive for Jul, 2015

Key value indicators

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The value of a business is, to a large extent dependent on its numbers – sales, gross profit, profit, and derivatives of those elements business owners will be aware of.

Most owners know that the real value is related by way of some formulas using those numbers in conjunction with multipliers, discounts and limits. But what are the latter all about? How are they decided?

In the spirit of all things graphic, as one does in the 21st century – apparently:

This short video illustrates very simply why strong businesses and weak businesses have different multipliers.

In the near future I will get more specific as to what exactly makes those differences, and the mechanisms behind them.

The ultimate customer

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“But it’s just not what we want”. The chairman of the board of the listed company was quite adamant. I looked at the shareholder, CEO and negotiator for the seller, who was gloomily flattened. The last few weeks had been harrowing for him.

He had insisted that the only purchaser for the business was this particular listed company. He had insisted that he knew where this – the ultimate customer – should be steering itself.

He had personally put together all the sales material. He had guided the data flow himself. It was an experience he was determined to live, anything but vicariously.

The deal failed shortly before Christmas of that year. The holiday season gave the CEO time to think. In the new year he vowed to do things differently; and he did. Two years later we helped ease the business into the control of an unlisted competitor on favourable terms to both buyer and seller, in an eventful tussle between competing bidders. Various interested parties were all unaware of who their rivals were, and were all protected from one another by a carefully managed, progressive due diligence process.

Some of the time from failure to success had been spent spent putting together a selling plan tailored to what investors in businesses, or people looking to buy businesses (the ultimate customers) actually want; as opposed to what the seller of the business thought they should want. Their dream, not his. The result was what he in fact had wanted all along – an exit on favourable terms, allowing him to move on to bigger and greater things.

The late Steve Jobs famously said “A lot of times, people don’t know what they want until you show it to them”. This uncharacteristically arrogant claim (some will disagree with part of the adjective clause), was some ten years before the iPhone 3G bombed in the Japanese market. When released, it would sell only 200,000 units in that tech savvy market.

With a second bite of the apple several years later, the iPhone 5s captured 34% of the same market once Apple had accurately determined what the Japanese market actually desired, and then delivering it in the form of the new phone.

So too, for business offerings down our end of the dark continent. Businesses which are worth selling, and which have in fact made it far enough to be valuable sellers, achieved the status by supplying what their individual customers actually want. So why should the eventual selling of the whole business be any different? The ultimate customer of the business is not going to just buy anything. He wants something which fits into his plans.

  • For a smallish operation, it may be something which simply provides an income.
  • For many different size operations, it may be something which can be rationalised to use up excess capacity of the buying company, to create greater value.
  • It may also be the means to a greater market, a particular product, some new technology, or a specialist operator.
  • For large operations it may be the vanity target of directors with a large war chest.

For all buyers, there is something which pushes their buttons – something which they need or want. But that imperative comes from them, and while business owners may be able to manipulate the greater market of their micro products over a period of time by way of marketing, talking and networking, when it comes time to sell something as significant as a business, it is unlikely that they will be able to influence the business buying market to such an extent as to have it see things their way, which also happens to be a contrarian way.

Bottom line: it is necessary to present things the way the ultimate customer wants them presented.


Out of WACC

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A previous suggestion that an increase in interest rates may cause businesses to suffer in their value, alongside with their cash flows and the well being of their customers caused a number of subscribers to contact me with comments.

  • “I remember those days in the late 90’s”
  • “I will never have an overdraft again”
  • “I currently have enough debt to start a small 1st world country”

Just a warning, of course.

Good times

When times are good and businesses are performing they end up with profits after taxes have been paid. Some of that will be paid out to shareholders; some of it will be retained in a business “for a rainy day”, to help the business to grow, or to simply avoid paying out taxes on dividends.

So the question at the end of the year comes down to “How much do we need to keep in the business? Let’s take out the rest and have a good time – we’ve certainly worked for it.” An alternative view is that it is good for business owners to spread their risk and invest some of their money in other asset classes.

Bad times

In tougher times businesses very often run out of money, and have a miserable time of it as a result. When that happens shareholders often rue the times when they removed their money to “have a good time”. It is very difficult to be in a place where salaries are paid late, rents go unpaid, suppliers are calling for payment and the lights might be turned off any day now. With no cash reserves they try to borrow money with a weak balance sheet. That is almost impossible, and if they do get it right, it is at inflated interest rates, which then climb higher with the bad times.

Of course bad times also mean higher risk, and sometimes the business owners want to get their money out of the business to ring fence it from the coming storm.

Somehow in all that we see the true value in a business. The owners don’t have confidence in the thing, so they take their money out. Banks won’t lend to it because they see a high risk. There is an inability to pay creditors. Sales are down. Margins are falling. You see the problem with the business value in such circumstances?

These times are coming for many businesses.

The balance

What do you do about it? What is the optimal amount of debt to have in a business? How much cash should be left in the business to tide it over these poor times?

  1. Borrowing money from a lending institution costs interest which is subject to increasing as the economic outlook deteriorates. Those interest payments are tax deductible.
  2. Borrowing from shareholders is often free, and as long as the business is solvent, the loans are easily repayable.
  3. Cash in the business bank account by way of previous profits left in the enterprise is top prize.

At what stage do we limit the borrowings of a business? How much cash should be left in the enterprise? How much can we pay to the owners, either as salary or as dividends?
Getting the balance right is relatively simple if all the facts are at hand. You accountant should be able to help you.

Interest rises drop a clanger

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Many of today’s business owners in South Africa will remember the 1990s. Interest rates were a talking point all the time. Negotiations around bank facilities, car loans and mortgages were routinely argued with riders such as “prime less 3” or even “prime less 5”, meaning that if the prime interest rate was 15%, then the loan would attract interest of 10%.

The movement in interest rates were a very movable feast, more often hiking up hugely from from one month to the next, then only very slowly coming down – or so it seemed. At the time South Africa was an indebted nation. That is to say that those with access to credit were heavily indebted and paying huge monthly amounts to banks, and certainly living on the edge.

Individuals were borrowing money to purchase small businesses, and using the business proceeds to repay the loans. Inflation was high, so generally speaking if cash flows were strong enough to obviously meet repayment requirements in the first year, the lender was fairly safe about being repaid in subsequent years.

Then the disaster occurred…

Interest rates shot up beyond the inflation rate. And then they went up again. And again. Almost without warning (it seemed) the prime rate was above 25%. This meant that loans were being repaid on enormous amounts, at rates today reserved for consumption borrowings of poor people. (How’s that for an indictment on the loan sharks of today?)

So those of us old enough to remember will remember this as well:

  • Consumer spending had to drop because consumers had much higher bond and car loan repayments, and no money for much else.
  • Businesses watched their profits collapse because of the double whammy of dropping consumer spending and their own increase in loan repayments. Lower sales turnover with higher operating costs and interest payments. A perfect cash flow nightmare.

For most businesses, this is where the primary struggle was.

But for those of us trying to sell businesses for people, there was another layer to this onion. Businesses were making much lower profits, so their values were already falling. But even worse:

  • Business buyers were being asked to borrow at higher interest rates, and so were not able to pay as much as before.
  • Business buyers who were cash flush and did not have to borrow, were earning much higher interest rates just to sit on their money, without risking it in volatile small businesses under pressure for survival.

So demand for small businesses went down.

On the other side of the fulcrum:

  • Business owners under cash flow pressure, struggling to pay creditors started looking for investors (who were quite happy to keep their cash in the banks at high interest rates – see above).
  • Business owners in real trouble, and unable to pay their bills dumped their enterprises on the market.

So the supply of businesses went up, in a difficult market.

An over supply in an environment of lack of demand. Values collapsed. They stayed collapsed for several years, and people looking to retire at that time were forced to hang on for better times. Some did not make it.

There is a feeling that interest rates are going to start going up again, after years in almost civilised territory. If they do rise, those who have cash will smile, those who have borrowed heavily will sweat.

But for sure; sales will go down, profits will fall and values will decline.

Lucky locomotive

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The founding spirit of small business in South Africa is based on “‘n boer maak ‘n plan“.

It seems this is becoming pervasive in our government owned entities following R600M worth of new railway locomotives having been delivered. That is only part of a R3.5B tender won under interesting circumstances by a Spanish company in the face of South African manufacturers suggesting around half the price. Nothing strange in that, as the water around these frogs slowly warms up.

What is interesting is that the locos are almost 30cm too tall for our railway infrastructure. Think about getting under our bridges and through existing tunnels, sure; but less obvious is the ability to safely, and without electrocuting drivers, staff and passengers, to travel long distances beneath sagging overhead electricity supply cables.

In the true spirit of South African tenderpreneurship the mistake is being transferred to being that of the engineers in a bygone (apartheid) era who

  • built the bridges too low, or
  • built the railway too high, or
  • used railway lines which are too thick.

Not to be outdone by a “challenge” masquerading variously as incompetence, stupidity or corruption prompted opportunism; and to make broad based transformation a reality, the locos are all being adapted for South African conditions:

  • They are being converted to soft top versions
  • Suspension is being lowered with modified sub frames
  • Low profile wheels will be fitted, and
  • For the lowest, most incompetently designed apartheid bridges, trains will be stopped and the tyres deflated.

This last option is expected to create thousands of new jobs in the form of tyre deflators, tyre inflators on the exit of the bridge, and newly registered train guards.

And finally, I kid you not because this sort of satire cannot be made up easily…. The Spanish manufacturer of this locomotive has called it the AFRO4000 series.

The South African conversion will be known as the ChiSKOP3.5GTi.