Posts Tagged ‘acquisition’

The most common hold-ups in a business acquisition

Sunday, February 12th, 2017

The most common hold-ups in a business acquisition are revealed in an exclusive video interview with Rob Goddard of Evolution Complete Business Sales.

The transcript of the interview follows:

It usually revolves around one topic which is that the buyer and seller or one or the other get lost in the detail.

They lose sight of the main objective which is to try and put two businesses together.

Or if it’s an investment play, that an incoming investor adds value to the business.

Often they can get lost in items of detail – what happens to the deal process is that it slows it down.

It also makes it more expensive because not only with management on both sides trying to iron out a deal, but if you’ve got lawyers acting – and accountants and other advisers – the bills quite often, particularly with lawyers, can extend. Especially if you’re playing your lawyer by the hour.

One’s got to be careful of dragging out the deal negotiation process unduly. It will get expensive and something comes into play – which will be the subject of my second book – which is deal fatigue.

Rob Goddard
With buyers and sellers there comes a point when it goes on for far too long and one or both parties just get tired of it all.

They keep going round the houses and nothing seems to be able to be crystallized. You can be 18 months down the line and there’s nothing concrete, nothing materialized and no agreement to go forward.

What does this mean for the deal?

Stalemate! One or the other will fade away, disengage from the process and you may have lost a year, 18 months, two years. Three years is the longest period of time I’ve heard about which is incredible. It should be done over a three, four month period to negotiate, to construct a deal.

And then get the lawyers involved and make sure the lawyer is on an hourly rate. Sorry lawyers, fixed price!

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Business Valuation – Three Approaches

Friday, February 19th, 2010

I got pitched a question last week from a principal of a software business.

He asked what were the most common valuation approaches used for valuing a small software company in a slow-growing market segment with revenues around £3m, growing 20% per annum. The company has good technology though not killer

We can come up with any number of valuation methods, but the only one that ultimately holds true for a private company is the market-determined valuation. This is the price a buyer is willing to pay and that a seller will willingly accept for the business for sale.

Potential buyers may have completely different reasons for purchasing the business. It may be that the buyer is specifically interested in the targets technology, for which a grander application is planned. Or its established distribution channels. Or its outstanding human resources. The market-led valuation approach implies that the methodology for valuing a business should be determined by the purpose behind the proposed purchase.

Although ultimately the most accurate, this approach is not overly useful in enabling business sellers to quantify their expectations. So I’ll take a quick look at some approaches used for justification of the setting of asking prices by vendors and offer prices by purchasers.

1] Asset Valuation
An accounting-based approach that subtracts business liabilities from business assets to arrive at the business value.

Simple at first glance you might think; but is difficult to know what assets and liabilities to include and to place a standardised value on them. If an asset is not included on the balance sheet – lets say a unique proprietary technology process, then it will not be accounted for in the valuation. Though you can be assured a business will always be worth at least the value of its assets less its liabilities.

More problematic is that this approach does not take into account the profitability of a business, so its application is limited for the valuing of most solvent trading companies.

2] Discounted Cash Flow
The Discounted Cash Flow (DCF) approach is a technical valuation technique used with companies, which are moderate to high cash generators or are soon expected to be cash-generative. It looks at today’s value (at a given rate of return) of the accumulated profits of the business over a number of years added to the value of the business in today’s terms if it were sold at the end of this period.

How might we apply this to the software company owner, if we knew his company generated cash and we decided to use this approach?

There are several ways to apply DCF. Here is an example where we shall project realistic cash returns for the next 5 years and discount them at a rate acceptable to an investor at 20%. So, let’s say the projected earnings of this software company added up over the next 5 years came to £2m. At this discount rate, that £2m in 5 years is equivalent to £800k today.

We assess what the residual value of the company might be in 5 years time (apply an industry multiple to the average earnings in years 3,4 and 5 with a weighting to year 5). To make the calculation simple, let’s say the residual value is £10m. Apply a discount of say 20% (well guess this is the acceptable investor rate of return) and you have a discounted residual value in today’s terms of £4m. Add back in the discounted cash flow: £4m + £800k = £4.8m.

Some investment banks prefer to use the more scientific basis for calculating the discount rate: the weighted average of the costs of debt and equity capital. Here’s an example. The business has post-tax cost of debt of 7% and an estimated cost of equity of 25%. It plans to raise capital 30% by way of debt and 70% by way of equity and computes the cost of capital at 19.6% as follows:

Capital Split Cost Weighted
Cost of Capital

So what are the problems with the DCF approach?
It is not easy to apply! To forecast the future cash flow of the business, you are going to have to prepare a full financial model. This is going to need some serious analysis of the business, the macro-economic environment, the legal and regulatory framework and the competitive landscape.

To complete the equation, we still have to make a judgement on the residual or terminal value of the business, for which there are several calculation methodologies. The terminal value is sometimes determined using multiples from comparable firms.

Or we can assess a terminal value by sticking to the DCF fundamentals. This is often called the perpetuity method and assumes a growth rate g of a perpetual series of cash flows at the end of the period (5 years in the software company example).

Tp = (CFp x (1+g))/r-g

Tp = the terminal value at the end of the period p
CFp = the projected cash flow in period p
r = the discount rate
g = the estimated future growth rate of the future cash flows beyond p

The other problem the valuer is faced with is that if the current or expected market conditions are turbulent, forecasting cash flows maybe pure guesswork.

Other complexities also come into play. To an extent the acquired companys future cash flows depends on the acquisition method and the purchase price. How is that? The acquired business’s future cash flows are directly affected by the taxes it will pay. The taxes the company will pay depend on its taxable income. And the taxable income will partly depend on its taxable deductions for depreciation and the amortization of intangible assets. These deductions depend on the acquired company’s tax basis for its assets, which in turn depend directly on the purchase price paid for the company.

3] Comparables Valuation
Here an attempt is made to extrapolate or interpolate the value of the business by using information collected on similar business sales in similar markets. This approach is the closest simulation of a true market-led valuation.

The market has paid x for ABC; the market has also paid y for DEF, therefore because of the similarities between ABC, DEF and YOURCO, we can estimate that there is a strong probability that YOURCO will fetch z.

Certain industries have their own rules of thumb that are commonly used as comparison standards for setting prices for businesses for sale. Usually these are profit multipliers for an industry sector within a country, but sometimes the rule is based on another variable peculiar to the industry i.e. barrelage in the pub sector, customer numbers for a mobile phone air-time provider. But just because a rule of thumb has been extensively used in the past does not mean that it is necessarily the right approach to take particularly when the rule of thumb is based on a criteria other than net profitability.

The profit multiplier or price earnings ratio is a common business valuation guide used, especially in the UK, when a business is both established and profitable. It saves us from having to deal with the forecasting issue when cash flows are difficult to predict. But always use this cheap and cheerful method with caution; the value you end up with may be substantially different to the figure produced by a business valuation expert with experience in your industry.

To see how this variance may occur, lets look at two hypothetical companies that operate in capital-intensive tech sector. Lets assume this sector uses a rule of thumb that estimates the value of a company as 6 times EBITDA. We will assume that these two businesses are identical in every way with the exception that one business has plant and equipment that is newer and more efficient, requiring much less re-investment in capital assets to sustain the business.

Company A and Company B both have EBITDA of £1m. Ostensibly, according to the industry rule of thumb, they are both worth the same at £6m. But Company A requires £200k of capital investment each year to sustain the business, whereas Company B needs only £50k. Would you not prefer to purchase the business with the higher cash flows? On close inspection it transpired that company B had substantially higher admin costs that could be trimmed right back upon acquisition giving the purchaser a much higher ROI.

Comparables valuation is a clearly useful approach when the right information is available on other companies that we know are similar in most respects. Unfortunately, this information is not always able to be collected. It is more often used in industries with simple business models and where there are many players. With larger and more complex business, there are fewer comparable companies.

However, in the absence of comparables, the profit multiplier technique is still widely used as a valuation yardstick. I often see private companies go up for sale for between 2.5 to 5x earnings (generally the higher the annual revenue, the higher the multiple). Why is it 2 1/2 to 5 times earnings? Well, to buyers, such a multiple represents getting their investment back in 2 and a half to 5 years from profits. That’s equivalent to a projected annual return on investment between 20% and 40%. And this is the type of return rate that encourages buyers to take the leap of faith to buy an existing business.

Buyers will often use one or more of these approaches to see whether the result of the calculation falls close enough to the asking price to give it some validation.

These are the most prevalent valuation approaches used in the market. If you are looking for more, you need only go to half a dozen business brokers or valuers and ask them to assess the value of the company and to explain to you how they get to the figure.

You will be amazed at the variances. As a special service to our Blog readers, we are offering a free business valuation from one of our in-house experts. Just complete our short valuation request form.

UK technology, media & telecoms industry still attracting interest.

Wednesday, November 12th, 2008

According to Freshfields Bruckhaus & Deringer, up until September 2008, the UK technology, media & telecoms (TMT) sector has attracted the second strongest and most widespread M&A investment since the dotcom boom. Only 2006 had higher levels of investment but this was due to the purchase of O2 by Telephonica – a deal that was worth some 17bn. 12.6bn has already been committed by foreign acquirers across 132 deals. A recent example has been the purchase of Messagelabs by Symantec for $700m.

The 12.6bn invested up until September 2008 is over three times the amount spent on TMT companies in the whole of 2007 and much higher than any year between 2001 and 2005. This has been also helped by more realistic valuations of UK TMT companies.

Foreign investment levels in UK TMT market
2000 47bn
2001 5.2bn
2002 758m
2003 4.1bn
2004 1.6bn
2005 3.9bn
2006 22.5bn (Telephonica acquires O2 for 17bn)
2007 3.8bn
2008 12.6bn

Back in 2000 the highest investments, in the TMT market, were made in the wireless industry which attracted 29bn. By comparison, in 2008 the highest investments were in the publishing industry with 9.9bn completed including the acquisitions of Reuters by Thomson Corp for 7.9bn and the sale of Emap to Heinrich Bauer for $1.4bn. By far the biggest nation investor into the UK TMT market is the US.

Natasha Good, TMT partner at Freshfields said In keeping with the global picture, UK publishing companies have been hotbeds of investment this year followed by operators in the software and computer systems industry. As advertising revenue continues to migrate from print media to online, depressed valuations of publishing companies, that are cash generative, have attracted buyers whilst some players are looking for consolidation opportunities to achieve economies of scale in a changing market.

However, investment levels by UK companies seeking to complete acquisitions abroad has fallen significantly to just 628m from a high of 159bn in 2000. In 2008 the US featured as the most popular country to invest in with 260m worth of investment across 35 deals. Last year India was popular with 6.4bn worth of deals.
Global M&A in the TMT sector for 2008 has unsurprisingly fallen significantly below the levels seen in the last 2 years. This in part has been due to the difficulty in securing financing recently for the sometimes very large transactions in this sector. It is likely that only corporates with strong balance sheets will be able to expand globally through M&A activity.
One large market for technology companies has been to supply banks and regulators with sophisticated trading and compliance software. The fall in volumes of trades and general activity in the finance sector will put pressure on these businesses and may therefore depress values. In addition the development of software by small businesses requires much investment so without the support of the banks innovation may be restricted.

In conclusion, due to the continued need to innovate in the technology arena it is likely that as long as sector valuations remain realistic there will be deal flow throughout 2009. Cash-generative publishing businesses that do not rely heavily on vulnerable sectors for advertising or subscriptions will continue to be attractive. to investors.

Gordon Browns promise to make Britain into a strong knowledge based economy is now more important than ever if investment is to be encouraged.

Tips for successful due diligence

Friday, January 18th, 2008

The importance of due diligence to the success of a transaction is often underestimated. I thought it might be useful to put together a few pointers to keep in mind while running a due diligence exercise on a business you are intending to buy. It is not a checklist there are a few good due diligence checklists around there is a good booklet available to subscribers of the Business Sale Report entitled Due Diligence – over 1000 Key Questions to Evaluate Any Business For Sale. You can download an extract here.

Plan it, scope it
Define the scope of the due diligence exercise and clearly mark out who is doing what, when. Work to a timeline. Dont waste time on areas that are not likely to cause any real issues or have any effect on the final sale agreement.

Employee issues
Thorough due diligence should pick up any issues, risks and potential liabilities relating to the sellers employees. For instance, check if there are any past or present employees litigating against the business. Do any of the employment contracts have unusual clauses i.e. over-the-top redundancy packages? What are the specifics of the pension plans?

Move fast, top down
It is important to spot any issues early on so that the appropriate warranties and indemnities can be quickly put in place. Focus on major issues first. As with any aspect of due diligence, the late uncovering of issues which lead to changed warranties and indemnities at an advanced stage can reduce strength of the negotiating hand and, (i.e. in the case of pensions) in some cases, even scupper the deal.

Communication is vital
The flow of communication between the buyer and his/her solicitors is of paramount importance, for if they do not work closely together, the process can quite simply fail.
Buyers must communicate the key issues of concern to the solicitors; they should not just assume that all areas are of equal importance, and that everything will be dealt with in good time. The solicitor must be told what the key commercial reasons are for the purchase, which areas are high-risk and which areas should be prioritised.
Continually monitor the activity of the solicitors and accountants carrying out your diligence and make sure they are giving you regular feedback.

Dont forget the culture
Funny how the lack of understanding of the targets company culture is one of the main reasons for failed acquisitions, yet has been notoriously ignored in the due diligence process. Dont make the same mistake. This is usually one for the purchasers management to consider, rather than delegating to legal or financial advisers. Map out the management styles of your business and the target business. Look at the core values of each and analyse the differences. How do the communication structures and styles differ? Look at the dispute policies.

Collect information, then analyse

Dont let any of your advisers analyse whilst collecting the information. These are two distinct activities within the due diligence process. First find out where the required information is, then collect the information, recording its source and noting whether it is fact or hearsay. Then start an objective analysis.

Dont panic, take your time
A focused but comprehensive approach is better than taking shortcuts in order to reduce costs. Often the buyer discovers that thin areas of diligence need to be covered again in more detail. It will end up taking more time overall and costing more money.