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

Archive for the ‘Business valuation’ Category

Why size matters (part 1)

Does your business fit into the definition of “Small Business”? Or for that matter, “Medium” or “Large” business? The definition varies from one industry group to another. And even within “Trade” it varies from one sub-group to another.

This table shows business sizes as grouped by StatsSA for South African industry sectors.

“Turnover” is the number at the head of your income statement. It does not include “other income” like grants, interest, rent, VAT and the like.

It is the sales turnover of your principal business, excluding VAT.

Those turnover groups have been varied from one industry to the next. My “hot air industries” notation is my slightly quirky reference to a whole bunch of consulting type activities.

The graph below will give you a more aerial view of the way in which sizes relate to one another and across different industries. There is no maximum for “large business”.

‘The one thing this country has taught me, Vaughn,’ said Griessel, ‘things never get as bad as you think they will. And things are never as good as you want them to be.’

Benny Griesel. The Last Hunt by Deon Meyer

So why are small businesses punching above their weight?

In the early stages of a business, the entrepreneur faces the envy of his friends who just don’t have the courage to chuck in the corporate environment and “go on their own”. Or they have to explain their risky behaviour to family members who feel insecure about the lack of “stable income”. But above all, they face their own fears, challenges, impostor syndromes, and bank managers.

Unless they make it big; and quickly, they are to be pitied. And that is also how they are treated when they ask for funding. But then along with the pity comes the distrust.

So to make my small business owner friends happy, here are a few metrics calculated directly from data supplied by StatsSA for 2018.

Just note that these numbers and conclusions drawn exclude banks, insurers, state owned enterprises, and the like.

Better negotiators

Small businesses managed to close off an average of 44% gross profit. The average GP% across all industries in 2018 was 41.5%. Not too shabby for my mates, eh? Gross profit is at the sharp end of running businesses, where the negotiating happens.

The small guys hold out for higher selling prices and convince their suppliers to give them better deals.

Look down the list: small businesses top most industries’ GP% where they have any chance. (There is not much space for negotiation in energy & water supply, mining & quarrying, and transport & communication.)

But for the other industries they do alright!

More working capital

NWC = current assets – current liabilities.

You will recognise that as the liquid assets available to first run the business, and second to build for the future. This you know because all business owners run that calculation last thing at night, first thing in the morning, and several times during the day. I’ve been told!

NWC is the single most useful day-to-day report metric for on-the-go management. If it is positive – you’re good. Negative, and it gets worse with the price of tranquilisers.

But when it comes to using it to compare with other companies it is fairly meaningless. Unless… A small tweak makes it extremely meaningful.

Net working capital ratio (NWCR) = current assets divided by current liabilities.

If the answer is above 1, then immediate liabilities are exceeded by what is available to pay them, now or reasonably soon. If the ratio is below 1, there is a problem now, or just around the corner.

Expressing net working capital as a ratio, we can compare the NWCR of a small business to a medium or large business. And within homogenous industries, these comparisons are very apt.

Any guesses?

For all industries combined in South Africa in 2018, NWCR = 1.15. It is positive. So there is that. But of course, I wouldn’t be writing this if the smaller businesses weren’t in the best shape of all the sizes. Here is the breakdown:

  • Small 1.47
  • Medium 1.36
  • Large 1.07

None of these are great numbers. Analysts like to see the ratio between 1.5 and 2. We’re all a bit tight here, as you may have heard.

But we do know that 1.47 is a lot better than 1.07. That’s small business for you – cashflush!

How does your business match up in each of these metrics? Remember the numbers quoted here are for 2018.

Step by step

  1. You know in which industry your business operates
  2. Place yourself in the appropriate size
  3. Gross profit ratio = gross profit / turnover
  4. Net working capital ratio = current assets / current liabilities

You can be quite sure that for 2020, those results will be very different. But we can only work with what we have, and I’m writing this with a view to showing up how unfair the system can be, and how the so-called “small business rescue packages” are actual, real, common or garden variety BS. And not the balance sheet type of BS.

To be continued…

What’s my business worth?

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Are you asking about business valuation or business pricing?

Price is not always value. Sometimes it will be. They are usually different numbers. The degree of difference will change with circumstances. Sometimes the degree of difference will be small. Often it is very large.

Here’s what I mean:

  • You buy an asset for its ability to improve your life. If buying your daughter a car will improve her life, it will improve yours too. The asset has value.
  • Buying gold improves your security in troubled political times. The transaction has a price to add value to your life. That value is a last resort store of wealth.
  • The price of Bitcoin has started to move again. Bitcoin still provides the same utility as it did last month. It is still a means for universal autonomy. We can still trade it around the world with as much ease as before. As much ease as when it was changing hands at $18,000. As much ease as when it was being sold for $4,000. The value of Bitcoin has not changed wildly in the last two years. Its price has.

The value of a business is an expression of what the owner currently gets out of it, and what he will get out of it in the future. He can sit tight and wait to get out of it what he expects but at later dates. Or he can offer the business to another person at a discount to those future cash flows. The essence of discounted cash flow valuation.

The key to value based on what you will receive in future times is the risk that those cash flows will not happen. But you know the ins and outs of your business.

  • You know how to deal with its creditors.
  • You know how to twist the screws to get its debtors to pay on time.
  • You have a good understanding by now of how the inventory cycle works.
  • You have been down a road with your staff members.
  • You have a deep understanding of what competitors are up to.
  • You know what marketing efforts have worked in the past.
  • You know about the wasted money on marketing failures. You won’t do that again.

To you; the risk in the business is small. So if you were to buy your own business, you would be happy to take it at a small discount to its future cash flows. Because… certainty.

By contrast, someone looking to buy your business has a lot of uncertainty. His learning curve will be steep. And yet you want to limit the hand over period to one month. You see the problem here? An uncertain buyer sees lots of risks. Of course, his value discount is going to be higher.

Now, do you understand the disconnect between a willing buyer and a willing seller? As much as you disclose “all pertinent information”. And as willing as the parties may be. No matter how much funding is available. The risk to the buyer is much higher in the raw and even higher in her own perception. There is no getting away from it.

Your job as a business owner (who will exit someday) is to reduce risk to your buyer. Your efforts will gain you a smaller price to value discount. If that sounds obscure; it means you will sell for more.

 

 

Business as usual

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Imagine your business is, or becomes, black-owned as defined in the BEE codes. You go for that big tender, but you still don’t win it, despite your favourable empowerment credentials. Your big non-compliant competitor wins it instead.


This post is also available on audio


In the disappointment which follows you assume corruption. It is our default position in so many industries. Rampant corruption is the one segment of our daily lives which knows no colour. It is the one real equal opportunity activity in South Africa.

But not all tenders fall to corruption. There are businesses of all hues, tones, and grey scales which do not win tenders. Are all winning competitors corrupt? Probably not. What if they have other strengths with which to bargain?

This is where vanilla black ownership fails in the BEE race for sales. For instance, many tenders go the way of the supplier who is able to offer very favourable payment terms. “Look you have a very poor scorecard, but we’ll give you the business if you agree to no deposit and 90 days payment. From statement.” It is the pain that some non-compliant businesses take.

Poor BEE level businesses have to win contracts with other strengths. If the business has big reserves. Or if it can back the terms off on its own suppliers. Or if it is in its own exclusive and strong niche. These are all gaps for contract winning strategies.

BEE imperatives aside, financing customers with long payment terms remains risky. And risk reduces value multiples.

The contract is value-defeating if it loads the customer exposure index, or if margins suffer. Value decreases if higher operational costs cannot be reduced after the contract and the inevitable project losses.

If the exposure the business has to a single contract is outside sound parameters, then key valuation indicators suffer. Valuation multiples fall. Discount rates rise. That’s ok if the profits rise in proportion to risk. Then values rise. Which is why winning tenders are often more costly to the end user. But then tender reviews become the risk. These short term gains can be very dangerous if there is no plan for life after the tender.

So the winning bidder may have financial reserves to fund the tender. He may have enough swing with his own suppliers so that they help him fund the transaction. He may be able to gain some margin in the tender.

Turnover is vanity. Profit is sanity. Cashflow is reality.

Ultimately the cash flow from the deal will work through to value. In the meantime, that promise of value will be tempered by an assessment of risks taken to gain the cash flow.

 

 

This little piggy went to market

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A market valuation is an expression of the expected offer price in a business sale. It assumes the current prevailing economic conditions and political sentiment. It also assumes an adequate demand from prospective buyers with access to capital.


This post is available on audio


The market valuation is also a product of strengths and weaknesses in the business. We call them key valuation indicators. Compare the KVIs to the financial statements to justify the valuation. They must align. Information must be accurate, and available in a standard format. The format is very often not standard. That does not diminish the value.

The valuer must draw on experience, exposure to deals, and insight of negotiations. This skill will inform the calculations and their variables.

The market valuation result is what one can expect the Business to sell for, as it is, where it is. It is neither definitive nor prescriptive. It does not take into account the vagaries of negotiation, greed, fear, and force of character. By definition of the balance sheet at the end of a financial period, valuation is also time-dependent.

The market valuation puts a stick in the ground. Use it to plan your next step. It is key to building wealth in your business. Don’t be the pig around the stick which rests above the coals of business transfer.

Storing storms

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Pierre Sussex was as stealthy as a Highveld thunderstorm. He walked his factory several times a day. He liked to keep his machine minders on their toes.

Each one had a schedule to work to. Pierre had worked out the best number of parts each machine could produce per day. “Local-efficiency” was his watchword.

Clipboards hung from the corner of each operator’s workstation. He designed reports so that he could run his finger down the last column at any time of the day, and pass comment.

Pierre regarded himself as scrupulously fair on his staff. As long as they agreed with him. Prayer time took place during tea time, Every day. “It keeps everyone focussed on not cheating me out of the time I pay them for”. He limped down the aisle between machines lined up in the factory.

Every machine with its own local efficiency. “Keeping machinery and operators on the move maximises my return on investment.

“But now it is time. I am 82 next month, and I have put this place in the right frame for a sale. My son agrees with me. And neither of us want to share the business with a black partner. He only holds 12% of the shares, and if we have another partner move in with us, then he will be a minor shareholder. With a boss who is not his dad.”

We walked into the warehouse. “Take a look at all this stock,” he said. “Efficient machine use and output justify their cost. My people must work. The stock must build up. We will always be able to sell the finished goods.

“We have a part for the battery of every single car which exists on the continent, right now. Nobody else has that. And our customers don’t like to hold stock, so we hold it for them. I will have to build on to the warehouse next year because we will soon fill this one. I put all my profits into stock. If we have a prolonged strike, we will be the only people on the continent with the right parts.”

On a wing and a prayer

We trundled off to the boardroom. And a prayer. Pierre was big on his prayer sessions. “We make specific parts for the internal part of a battery. They are very specific to each battery size. But our market is opening up now. The new batteries required for the new electric vehicles will all require our parts.

“No, I don’t have any fitted beyond the prototypes right now. But this technological wave is moving fast in our direction. I think we have enough finished parts in the warehouse to supply for a year without having to turn a machine. You know we are in for big political and social upheaval in this country. It is not the same wonderful place I grew up in. I worry for my grandchildren.

“Anyway, here are the financial statements. I want 200M for the business, and then we can talk about the property as well.”

I put my head into the accountant’s office. “Any chance you can get these to me on email?” I asked. We stopped using paper in our office five years back. It had become a nightmare of control issues over clients’ private papers. The risk of fire, and the sheer storage space required, notwithstanding. We prefer electronic storage.

But back to Pierre and his business. He was a new client. He was 82. He was also an old client. He thought it was a good time to find another owner. He wanted us to manage the process. We had done so for a family member of his two years before.

He was also stuck on the 200M. And that was a problem. Our job is to manage these merger, acquisition, and disposal processes. We have been doing so since 1991. That is a long time in which to learn what works. The stuff which does not work fails for business sellers almost daily.

So there I sat with a hopeful business owner. He had a target upon which he had based his entire retirement planning. He was secure in the knowledge which closeted his own perception of value.

But he was wrong. And that is devastating to a person who wants to get back in the saddle on a farm in the Western Cape. He was tired of the staff, and the sirens, and the stock control, and the late payers, and the approaching social upheaval which he believes is coming.

He was wrong in as much as his business is not worth anything close to 200M. It is not even within striking range of that number. But he has believed for the last decade that this is exactly where he would step off the tram. He has not once, asked for a proper opinion of the value of the business.

Had he done so, he would have been able to adjust his expectations and those of his family. But more likely, he would have been able to address the weaknesses in his business. He may have been able to turn the weaknesses to the benefit of his future.

Get your AFS into gear

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Jim’s business was jalapeño hot. He told me all about it in about 30 seconds of polished elevator pitch over a poor cell phone line. It got me into my car on the way to Springs within half an hour.


PrepareYourBusinessForSale™ is all about getting exactly that done. But in going the PYBFS route, you also get to add value to your business. Here is why.


Early engagements

I walked into an old house. It had been kitted out for the administration of a business designed to churn out products in volume. We had a good natter. He told me some stories. I told him a few of my own. We drank his very nice coffee, and a few hours went by as I went through my interview process.

The house was one the owner had inherited from his mother. It was more than adequate for what it housed.
The growth curve of the business had been steepening. Jim felt that he needed to get an equity partner into the operation to help fund the continuing growth. The only thing that did not flow in the day, was the financial information. There were some issues. “But I will get onto my auditors as soon as you leave, and I will email the financials to you before the end of the week.”

Cape Town

The next day I had an appointment with another business owner who also wanted to sell his business. This time in Cape Town. He had arranged for me to see him as soon as got back from his trip to Italy. So I was up early, and onto a plane. I spent the better part of an afternoon with Mario as well. He also had nice coffee.

Mario has had his business valued by us every year for a long time. He had sent his latest financial statements to my office the previous day. My team picked them up and started putting them into our valuation model.

He also had a very nice business which had a similar problem with growth. He needed to buy some impressive machinery so that the business could continue to grow at the same rate. His financial advisor said it would be a better idea to sell some equity, rather than push the debt level higher. So that was what he intended to do. I am not a financial advisor. I just listen to those guys.

Network

We maintain a detailed mind map database of businesses, funders, and clients. It’s a veritable who owns whom, gleaned from discussions and web pages. It has now grown into a thing of beauty. A few years ago, it was more rudimentary than it is today.
So on the plane home, I went through the database mind map. I kind of killed two birds with the same stone, mid-flight, so to speak. I was looking for relationships between each of two clients and listed companies.

As it happened, Jim had more prospects for what we thought he wanted to do, than Mario did.

When I got back to Jozi, Mario’s financial inputs were complete. I was able to start the pitch analysis with a full deck of cards (and a search for a few more metaphors to throw into the mix). We still always start with an exercise to determine what the market would bear. We do this for every new client.

We stepped up our research of the agendas of the targets for both businesses. For targets, the easiest route to growth is often through acquisition. The intelligence gathering has always been very beneficial. And boy does our industry talk about who wants what. So keeping the database up to date is easy, albeit time-consuming.

It was going to be an interesting time, I thought. The weekend came, and so did Monday. As always.

I called Jim. He was still waiting for his auditor. There was another problem.

Processes

We collected the rest of Mario’s documents which would be necessary for the sale. His web person made some changes to his website which we thought would help. Jim made similar changes himself. He was very good at that sort of stuff.

Both provided company documents for interrogation during a due diligence. We quickly added debtor lists, supplier agreements, bank accounts and employment histories. They were all easily forthcoming from both. All was going well, three weeks into each respective engagement.

Except Jim’s financial statements were still not available.

I should explain at this point. We always ask new clients to supply five years of financial statements. We can build a very good story from that sort of history. Jim could give everything except the last two years. We had all Mario’s history on file.

Jim’s trial balances and draft income statements for the last two years showed great results. There was no reason to doubt them. But it is the financial statements which investors want. The ability to provide annual reports in good time tests the whole governance issue.

Mario goes to market

Six weeks into the Cape Town engagement, and we had prepared Mario to talk to investors. It did not take many, and he had something which made financial sense. His machinery would be ordered soon.

Jim, in the meantime, was struggling. But he was also getting pushy. He wanted to talk to investors as well. So, he sat down with one of them. It was a great meeting. They loved what they saw. He would have the financials to them next week Tuesday, he said.

Tuesday came. The investor called. It looked like it would take a few more days. “A really fine business”, said the potential investor.

A week later, and Jim wanted to see another investor. “Just to have a plan B”. But he was already screwing with Plan A. But he met with Plan B. Then with Plans C, D, and E. And still, the auditors (apparently) were dragging their feet.

All the prospective Plans A to E did not so much lose patience, as simply wander off elsewhere. As business owners, we have limited resources. Sometimes we need to appreciate that the attention span of professionals, faced with various options, only have so much bandwidth.

Jim gets his stuff together

Jim’s financials were published. The trial balance figures were largely confirmed.

Plan A came back from his trip. It was difficult to get hold of him. When Jim did, he did not have much time to talk. Another fantastic deal had presented itself, and he was going hell for leather after it. “You know, that price may have been a bit steep”, he suggested. “Let’s talk next month”.

When Plan B did not return calls, Jim worried. So when he spoke to PlanC, he had lost some of his form. By Plan D, the picture was not pretty. The closing price was always going to be lower than the original nibble.

And over to you now

As much as this is a fiction, it is only partly so. I have written this with a collection of similar experiences over more than 25 years of helping business owners to change their lives. When a business for sale cannot provide information quickly and accurately, the momentum in the deal is lost. Value suffers. Always. When the third prospect goes cold, the seller gets desperate to keep the others happy. Silly things happen.

So what about your financial statements? Don’t be like Jim. Be like Mario. Don’t let them stand in abeyance with your auditor or accounting officer for more than six months, at the outside. If you can get them into your filing cabinet within four months, you will have the edge.

Business valuations | Various applications and costs

Accurate business valuations empower you to make proper decisions.

Divorce or partnership valuations

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When partners split up, there are problems with money and value. Almost always. Oh yes; there was that one time…

This post refers to a dissolving marriage as a model. But the points made, hold for most partnership dissolutions. They are not pleasant, but applying some rules keeps things fair.

Complications arise when married people split their joint estate. If one of the assets includes a business, the recipe is more than “take the white from the egg”.

  1. What is the value of the business?
  2. Where are business proceeds entering each spouse’s pocket?
  3. Open and fair negotiation

1. What is the business value?

The dissolution of any partnership is a transaction itself. It should be accounted for, with a market-related valuation. Business valuation methods start with the company’s financial statements. But the concurrent interrogation of key valuation indicators in the business is critical.

Competent and confident valuers are bold in declaring shortfalls in the discovery. Do not ignore their messages. The valuer will have taken heed of the shortfalls, in arriving at a number. Those noted shortfalls can provide valuable information for later use.

2. Where is each partner currently benefiting?

Every valuation accounts for an element of “normalising” the income statement. This involves removing or adding items which are “out of the ordinary”.
That exercise should also examine what each partner receives before the dissolution, and adjust for what each will receive after the dissolution. Consider adjustments for replacing the partner in day to day work. Understated assets and income, or exaggerated liabilities and expenses mean lower business valuations.

3. Negotiation

A fair negotiation recognises pre partnership equity. The change since then is what you are after.
A fair settlement considers an ex-partner receiving double recovery for a single asset. That would be inequitable.

The most significant asset in a marital estate is often the family business. A fair resolution hinges on an accurate valuation of it. Work with an experienced valuation expert who understands sound valuation concepts. Don’t play the “tarms 20” game.

Motivation in valuation

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Here’s a game I don’t play:

  • “look I need to have as high a value placed on my business as possible, for purposes of
    • taking my partner for as much as possible
    • to prove to my bank that my balance sheet is really strong
    • to show my employees that the long term investment plan is worth them getting no increase this year”
  • “I need you to keep the value as low as possible so that
    • my ex-wife gets nothing
    • I can offer this guy almost nothing for his shares
    • to make a stupid offer for the business”

If Suitegum conducts a valuation on your business, you should understand that under the conditions mentioned in the report, you are going to be able to get that value for your business in the open market.

I have a simple test for the veracity of business valuations which leave my office:

  • If this valuation is too high, to what extent am I exposing us to a damages claim from the owner of the business being valued when he is unable to realise the value, and exposes himself unnecessarily?
  • If the valuation is too low, to what extent would a commission based broker lose out on potential income if he sells it at that value?
  • If I am hauled in front of a bunch of geniuses (auditors, attorneys, judges, magistrates) will I be able to defend each and every finding in the valuation report?

So far that has worked out well.

So when I received a phone call last week suggesting that our valuation had been cast aside in favour of two other valuations conducted by auditors, both of which came in at more than twice the Suitegum value; I sat up straight and asked a few questions.

The circumstances are that the client has had his business valued by us several times over a six year period. The results have been consistent with time and performance. He found himself in the divorce courts in recent times. It wasn’t pretty. A liquidator was appointed to give judgement as to the value of a minority interest.

He kicked the Suitegum valuation into touch, and appointed two audit firms to conduct their own investigation.

In the final analysis, the liquidator was working for a proportion of the valued figure as his remuneration. We have a valuation competitor in the market who charges on that basis. Somewhat compromising, I believe, and in violation of the USPAP (Uniform Standards of Professional Appraisal Practice). With time, someone will test those valuations. Perhaps there will be some explaining to do. Probably not.

Auditors are not covering themselves in glorious integrity at the moment. A profession becomes a business when it chases money at the cost of principle. Why do we expect professional bodies to hold them to account?

Hashtag: 6 CAs on the board of Steinhoff.

 

Imagined reality of business value

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The owner of a business has a reality of value based on his real experience of the benefits which flow to him on a consistent basis. He knows 100% that “the business” makes money for him. He knows that it is more valuable to hold on to it, than to sell it below that value reality.

If a perceived premium offer is made – one which tips the scales of value from worthwhile holding, to worthwhile disposal; the run of play changes. In other words, if the offer received “makes sense” in that the owner will be happier as a former owner than as the current owner, then he will sell.

A buyer of a business can only act on imagined reality. Sure, that imagined reality is based upon thorough investigation; but until it is actually lived, the reality can only be imagined. That imagination is unique to the human race, and I suggest is bound up in the fear and greed dichotomy which grips us all, in all the decisions which we make.

For a business owner to dispose of his business, it is incumbent on him to translate his reality of value into perception of value – imagined reality – in someone else’s hands. Again, in other words; he needs to convince the purchaser of the value. Essentially, he needs to sell the darn thing, just as he would sell anything else.

That is what we strive to achieve with our clients – in helping them through the “PrepareYourBusinessForSale™” program to make them “Prepaired” with their eventual new masters. “Prepaired” is not a spelling mistake. It is what shareholders do in advance of selling their equity: They identify the market, and they make what they’re selling, attractive to that market. They pair their offering with the anticipated requirements of the future owners. They get “prepaired” through PrepareYourBusinessForSale™.

Where realised value meets imagined reality – made incarnate through the transfer of retirement funds. That’s a good thing!

 

 

Does your business need an auditor?

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Does your business need to be audited?

  • Perhaps your memorandum of incorporation or shareholder agreement insists on an audit.
  • Perhaps your business is within certain industries which require one.
  • Perhaps your funders require an auditor’s report annually.
  • Or perhaps you believe still, that all companies need to be audited?

If your PIS falls below 350, you do not need to be audited, and you may be wasting a great deal of money on the annual event.

Oh, but perhaps, just because a firm of auditors send an accountant around to your business every year, you believe you are being audited. Perhaps you are simply being reviewed.

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