A while back I suggested that business owners should spend less time worrying about their sales turnover, and consider the importance of net profit when apportioning value to their businesses. While that certainly puts us on the right track, it may also lead down a trail of misrepresentation.

The basis for the earlier assertion is that buyers of businesses are looking for a return on investment, and similar businesses with similar sales figures will be differentiated in their value by the bottom line. Nothing wrong with that assertion until we introduce some other variables.

You may recall that both businesses we previously spoke of were in different cities, manufacturing the same goods with the same turnover and similar expenses, but one had a lower cost of sales because it is closer to its principal suppliers. It had an immediate advantage with stronger cash flows, and after paying the same expenses as its counterpart, ended up with more profit. We concluded therefore that the more profitable business would be more valuable, and we are probably correct.

So for the purposes of this discussion, let’s assume that all those variables are equal; the two businesses are very close together and now have the same suppliers at the same prices, and therefore the bottom line is the same for each.

Fixed Asset Value

The variable we will introduce now is in the fixed asset value of the business. One business invested heavily in equipment twenty years ago. At the time the owner was lucky enough to be granted a loan to get up and running, and he bought his equipment very wisely. He concentrated on good German technology, perhaps spending a bit more than he could really afford at the time. But heck, it has been worth it. He has hardly had a breakdown.

Every year he takes his wife to Europe for two weeks where they spend two days justifying the trip by “visiting the factory parts division” where they purchase the dies for the next year, even if last year’s dies were only installed six months ago previously. Having placed the order (which may as well have been done online) they continue on for their annual ski holiday.

A business like this will typically have written off in their books all the machinery except the new delivery vehicle for which they paid cash. So the equipment has very little carrying value and would probably not fetch a very high price on the open market given the new computer controlled wizardry that is available today – the same electronics that makes the replacement value sky high.

On the other hand, Darrel

This business’s neighbour with the similar profit has done things differently: He was never able to get a loan because the government had introduced some social engineering into the mix at the time he got into business, and money was less easy to get hold of for him. So he relied on supplier rental finance to start with, scraping and battling along until things started to happen. With growth he invested wisely in new equipment, replacing and modernizing, and then as the whole factory hit its sales and production straps, he was able to really go to town on the latest and greatest.

He does not have the old workhorse machinery that will never break, but he does not really need to worry about that because he has a good replacement and modernising policy. The machinery is taken apart every year at the annual shut down when agent trained technicians move in, replace, lubricate and provide a new warranty for the next twelve months.

So which business is more valuable? Answers on the back of a R200 note and send to….

This situation immediately takes the “multiplar-bar-twenty” crowd out of the equation as far as providing a reliable valuation is concerned. The first owner would perhaps be grateful, but the second one would be leaving cash on the table, without a doubt.

This is a very simple example, and of course, there are other variables which come into play as well which we will deal with later. When they are all taken together, some interesting dynamics mean that valuing a business is best left to professionals who know what businesses really sell for at the current time, in the current circumstances.

The sale of a business requires a rental agreement. The sooner you ensure that you have yours in your PYBFS file, the better. Why do I say this? Many business owners do not have this very important document because they have never received a copy.

Mad rush

Think back to the time you signed your first lease. There was a mad rush as you prepared to get the whole show on the road. Then there was a rush into the rental agent or landlord, some last minute reading, and queries. Then you rushed out the door to get the next step in place. You know you signed the document. Somehow the landlord always signs last. They called you later, or more likely you had to make several calls yourself. They told you the agreement had been countersigned. In the excitement of moving in, you never received a copy of the agreement. This holds true for a great many business owners I see. Whatever the circumstances, make sure you have a copy of the lease agreement, and place it in your file. Make a scanned copy and save it to your PYBFS desktop folder.

Lease reductions = higher value

While we’re on the subject of lease agreements: You should take any opportunity to lower your rental. You would be well advised to do so in the tough economic conditions we’re currently wading through. You can renegotiate at the end of a lease term. If you’re a very persuasive character, you may be able to negotiate a lower rental cost midterm.
Every Rand lower your rental, your profit will rise by the same amount. This much is obvious. The value of your business will rise by some multiple of each Rand saved. That extra value will go to your pension fund for its own growth, and so on.

So, how can you persuade your landlord to drop your rent to last year’s amount? Or can you persuade him to forego the annual increase this year? Keep in mind the effect on valuations, and you may find yourself negotiating with a bit more vigour!

Depending on your industry, you may think about negotiating a new lease in advance of selling the business. For instance, a retail store without a lease is no longer a business worth selling. Retail landlords know the value of the lease to their tenants. The landlord must commit to the new owner with a lease on the same terms and conditions as those currently enjoyed by the owner.

Most factories can be moved, albeit with some difficulty, and the move shouldn’t trouble the customers too much. Of course in boom times, suitable factory space can be difficult to find. But then again; are we in boom times?

When a potential business investor looks at what he’s buying, he wants to know exactly how the business derives its income.

What do you do?

Businesses receive money in exchange for one of two things; the sale of goods or the delivery of a service. Perhaps there is a combination of the two. Sellers are often complacent in describing the activity or product. It is easy for this to happen because they are au fait with what they do. Their conversations run away with details of plans and opportunities.
Slow it down a bit. Describe from first principles the background need for your product or service. Where does your business fit into the supply chain of an end product? Where does the final product benefit the end consumer?
It is important to give your prospect a bit of a background to the products or services. If you place the story in context he will find his bearings sooner. He is less likely to shift his interest to an easier to understand business.

Pressure in the minority

You will do well to remember that yours is not the only business on the market. So make it as easy as possible for the buyer to understand things. You want lots of interest. The negotiating power of the seller goes up with the number of interested buyers.

Vaguelly specific

Do not create problems for yourself in the supply chain, or in the market. Avoid using brand names unless you have sole or proprietary rights to a product. If you have a clear competitive edge in a very full market, then the exposure may help the sale. But be careful about letting suppliers know that you ever intend to sell. Suppliers pulling back credit limits can damage your sale prospects.

Non-disclosure agreements are a good start, but they are not foolproof. A drunken braai saturated yob, who looks like the kingpin Monday to Friday, can do you a lot of unintended damage on a Saturday afternoon with his like-minded friends.

Sometimes you need to look at the end effect of what you’re trying to achieve, at the start of, rather than during the process. So, let’s jump ahead to a time when you actually sell your business, or (as I like to remind you) have it sold for you.

He said, she said

There will be an agreement of sale, which should be in writing. Even though verbal agreements are binding, my experience is that verbal agreements are worth the paper they are written on. There is too much of the “he said, I said” for verbal agreements to make sense.

At the time of reaching that agreement, the question of restraints will be raised twice.

In the first instance, and most obviously, you will be restrained from competing against the purchaser and your old business for a period, in a region. Give some thought to the consequences and start planning accordingly. Think about what you are or not prepared to accept, and if there are a whole lot of reasonable conditions you are not prepared to accept, ask yourself why you are selling this business in the first place.

It is reasonable for a purchaser of a business to expect to not have to compete with the guy who knows all his customers really well. Allowing the seller to market himself to these same customers could put any new owner out of business really quickly.

What have you been up to?

The second, less obvious instance of restraints, refers to the restraints that your business itself may be subject to. Many buyers’ attorneys ignore this very important element for some reason, I suppose because it is not so obvious.

But can you imagine the problems which would precipitate out of this situation: A buyer, makes a careful study of the target business and is satisfied with the cash flow issues discussed with a seller, and decides to buy. He then satisfies himself that together with his plan to acquire the rights to several other lines, the value of this investment warrants him taking out a second bond on his home, and borrowing some money from his elderly parents. Six months after the deal has been consummated, his biggest and most important supplier pulls the plug because the seller never told the buyer that this major supplier had only agreed to supply him on condition that he did not represent the supplier’s biggest competitor, which the buyer now does, albeit without being aware that he has breached an agreement.

When Suitegum is involved in the transfer of a business it does so, generally on behalf of the seller, but in good faith for the purchaser as well. One of the elements which we interrogate through our valuation process is the integrity of, and the exposure to suppliers.

So…

Think about what restraints you will be prepared to subject yourself to, once the business is sold, and have another think about what promises you have made to suppliers with respect to giving them special prominence in your business. The latter should be listed in your PYBFS files, both electronic and hardcopy.

If there are more than just you as a shareholder in your business, chances are that you have not put in place one of the most fundamental building blocks for the creation of value in your business:

The shareholders’ agreement

Let me explain. (Oh, and even if you are the sole shareholder in your business, you should pay heed.)

The shareholder’s agreement is more than a document governing the number of shares or percentage of shares held by each person (or entity). It helps deal with the other shareholders’ family in a time of crisis. It provides you all with a negotiated plan of action in the event you are incapacitated on a Sunday evening. It is something which can possibly stop your bank accounts being put under stress by the wife, girlfriend or children of your now dead partner.

The shareholders agreement will dictate how shares, or even the whole business will be sold or otherwise dealt with in the case of a fallout of shareholders. When you guys got together you never considered that one day there would be a divorce. The state forces us to contract for this eventuality in our personal lives, or face the whim of the courts. But in our business lives, which usually get started some time after our marriages, we are reluctant to take the same steps.

The shareholder’s agreement will help to protect minority shareholders in the case of a sale of the business. If you own less than a portion of the total equity, you are at risk of arriving at work tomorrow morning to find that in place of your shares, you have a cheque for the proceeds of the sale, which you knew nothing about.

A shareholder’s agreement can insure that all shareholders have a preemptive right of first refusal on the sale of any of the other shareholders’ shares. That can be very valuable in five years time when Big Larry wants to take off with his mistress.

A shareholder’s agreement can regulate the manner in which new shares are issued, and give you some say in the manner in which new issues are taken up, and by whom.

What happens if one of the other shareholders is a company, and that shareholder’s shareholding changes? Concentrate here. The control of your biggest shareholder changes to that of your competitor, or your ex wife’s new boyfriend… You don’t want to find that your electronic key no longer works on the first of next month.

What have you agreed to in the event one of your shareholders is sequestrated or liquidated?

How, or on what basis will you value the shares of the company in the event one of the shareholders wants to sell his shares to the other shareholders?

How will the shareholders’ loan accounts be handled in any of the above circumstances? And how will funding be sourced and repaid?

What is your agreed dividend policy; or do you simply have an argument at the end of each year? Wouldn’t you prefer to have left some of that money in the account after the last financial year end?

Many businesses actually fail because this very important document is not in place to regulate the way shareholders direct the directors, who (let’s face it) in our realm, are usually the same people. Such a failure leads to all the shareholders losing all the value built up in the business from the start to the time of the failure.

But most important, one day when you decide to sell the business, and all has gone well, how will you agree on the method of sale, and the distribution of the proceeds?

If you are a one man shareholder, read the above again, and give it a think. What will you do when someone offers to buy a portion of your business one day. I know what you should do. Visit an attorney with all these questions, and a bunch of others I have not brought up.

But there is more…

The memorandum of incorporation (MOI). The government put this into place for us a few years ago. Of course we were given an opportunity to make it agree with what we intended in the shareholder agreement, but most of us didn’t bother. The problem is that if there is conflict between the MOI and the shareholder agreement, then the MOI will hold.

Really. It may really be time to spend some money with an attorney.

In PBFS015 we ruffled a few feathers in the retail industry. I suggested that the value of retail businesses is very volatile. You will remember I said that retailers are at risk and are exposed to the effects of interest rate changes, government policies and global crises.

So what about other sectors – the rest?

Obviously these businesses are also at risk of the external factors pressing down on their full over draft bladders. But I would venture to say that on the whole, the effect on them is much less dire, with some exceptions.

Some consultants and “luxury” suppliers are perhaps almost as volatile as retailers. The so called corporate gifts businesses lose their finger nails on a slippery slope of cut backs by their customers in hard times. Their biggest exposure is often the fact that they are single parent stores with only a few customers. If one large customer pulls back on ordering, the entire net profit of the business may suffer.

The saving grace of the corporate gifts business is that most of them operate from home, and unlike their retail cousins do not have huge rental bills waiting for them at month end. They are more likely to remain in business during tough times; and like retailers, their multipliers fall precipitously.

Wholesalers to the retail industry are perhaps even more volatile. At the first whiff of trouble, their customers, having ridden the crest of a very profitable wave are quick to “destock”, driving their store room volumes down. Not only will a wholesaler’s customers purchase less, but they will actively actually not buy at all and cancel orders, leaving the wholesaler with an over stocked business, and all the risks that entails. In tough times they tend to shed customers while surviving customers purchase less. It seems though that their biggest customers survive the tough times, and a boom happens as the retail sector wakes up in the upturn. There is a big shift in multipliers in the wholesale sector, from boom to bust times, although not as remarkable as in the retail sector.

Factories are much less reliant on the position of their premises than are retailers, and are able to move routinely, with the exception of a few for whom their buildings are purpose designed. Most factories though, have to relocate as they grow, in order to survive anyway. Moving premises is used as a marketing opportunity, rather than being regarded as a marketing catastrophe. Tough times for factories usually result in lower utilization of capacities, less money spent on overtime payments, lower raw materials costs and a sharpening of the pencils of salary negotiators. The biggest impediment to factory values in tough times is the access to credit for prospective purchasers, and there are therefore fewer of them. This naturally drives prices down, but not nearly as badly as for the retail sector.

Franchises are generally retail businesses, but not always. Somehow they are less volatile in their value than other retail operations, for reason only of the perception being that they are part of a stable operation, and have huge marketing budgets behind them. In difficult times their undercapitalised competitors go to the wall, reducing the number of slices the pie needs to be cut up into, even if it is a smaller pie.

There is another albatross following franchisees, viz. the franchisor and his debtors department. This is a sting in the tail of franchisees’ income statements, particularly where the franchisors do not reciprocate the royalty and marketing fund contributions with a strong brand, and even stronger marketing effort. The effect of this comes to the fore in tough times. When strong stand alone businesses are able to net less than 5% of their sales, outlets of weak franchise systems are contributing all of this to their overlords. So where strong franchise systems command good multiples, their weak counterparts do not.

We will unpack this some more, later in the series, but for now, I hope I have illustrated how foolhardy it is to compare notes with friends in other industries, using the multiples they achieved in the sale of their businesses which may have been in an entirely different industry, different geography, different economic cycle, different … etc.

Brian Tracy said “ Failing to plan means planning to fail”
In the mad rush to increase turnover in the run up to a sale, the very essence of the business is often ignored – its raison d’etre: The bottom line and the sustainability thereof.

The formula seems simple: Raise the sales, cut the expenses any way you can, show a magnificent profit; sell to some greedy purchaser.
Unfortunately it is not this simple for a number of reasons.

• Good quality business buyers and investors always make their agreements of sale subject to a suspensive condition of sale (or condition precedent) in which they require to be satisfied as to the state of the financials as well as satisfactory answers to a lengthy due diligence questionnaire which they will have formulated over several years. During this process they will look for sustainability.
• Businesses do not always sell quickly. In fact very often they take a long time to be sold, and during that period they will need to be sustained themselves, for themselves. There is no clause which allows a business to deteriorate during the due diligence and financing phases but which still locks in the purchaser. (Well I suppose there is, but you’ll struggle to get a buyer to sign it.)
• Businesses need to grow, but at the same time remain sustainable and fundable. Uncontrolled growth sucks up cash flow better than any super sopper mopper you have ever seen. With an impending sale looming, quick last minute growth will sound the death knell for most sellers.

As with so many things of any value in life, businesses need to grow in value in a well structured and planned way which takes time and patience, and they need to have the following elements in place:

• Sales, margins and profits
• Infrastructure
• Intellectual property
• Sustainability
• Balance sheet

Sacrificing margin to grow sales helps nobody but the psychologists. Raising sales through good marketing efforts while maintaining margin is great. Great that is, as long as your infrastructure is in place to sustain the delivery to customers. But very often, the infrastructure spend bites into the profit line. Worse than that, spending on more staff and the delegation of responsibilities can also bite into the intellectual property of a business, and where the barrier to entry is very low, even bigger problems can arise.

Strangling a business through ensuring sustainability without pushing the risks a bit will ensure that you have a boring stagnating venture that you wish to sell, if only to stop the boredom.

Planning makes the difference.

Just as planning for the sale of a business will make an enormous difference to your life when the sale happens, so planning the growth of the business beyond just adding sales to the top line will allow the business to grow in a controlled manner rather than in fits and starts of feast followed by cash flow crisis. Your added sales may bolster your cash flow initially, but where will your inventory come from, and who will finance it, pack it and ship it? Who will provide the extra after sales service and explain to the greater number of customers how the widgets work? How will you collect the money, account for it and bank it? And how will you survive in the meantime?

Working through bottle necks in advance will not only save you a lot of grey hair, but will also add value to the business long before you have to, or want to sell it. Of course the added benefit is that you get to enjoy stronger cash flows while you still own the business.