The future of the economy looks to be a brighter place for UK businesses as confidence has returned to pre-recession levels, say BDO Stoy Hayward in its latest report. The accountancy firm’s Optimism Index rose from 99.4 to 103.2 in March; a high not achieved since the summer of 2006. The Output Index also improved, and has reached quarter three 2007 levels due to businesses re-stocking.

This renewed optimism is reliant on the three main political parties outlining their economic policies for the future, however, according to BDO.

The accountancy firm said: “The lack of information from political parties regarding concrete plans to tackle the deficit will be contributing to business uncertainty which in turn is keeping investment levels low in 2010.”

In other encouraging news, activity in the construction sector of the economy picked up last month according to the British Chamber of Commerce. The CIPS Markit PMI construction index rose from 48.5 to 53.1 in March the first time in two years. However, construction businesses might be vulnerable to reduced government spending on building and infrastructure projects. Read our guide on how to buy a construction business by subscribing to the Business Sale Report.

The importance of due diligence to the success of a transaction is often underestimated. We 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. A more thorough explanation of what is required is available to subscribers.

Approach the whole process with a very objective and critical eye. When you have seen a business to buy it is very easy to get carried away and marvel at your own cleverness at seeing such a good opportunity. But always remember that it is much easier to evaluate what has been presented in a memorandum of sale than to spot what has been left out.

Get the right advisors

Buying a business is a team effort and the most important members of your team are your accountant and your solicitor. Make sure that you have a good working relationship with both and they are properly instructed. If you need to appoint new advisors do so on recommendations to ensure they have the appropriate skills.

Plan it, scope it

Define the scope of the due diligence exercise and clearly mark out who is doing what and when. Work to a timeline. In order to conduct a thorough investigation you must have everything in order before the due diligence process begins. In fact, you must start your due diligence preparation and information gathering the moment you decide that you are interested in a particular business. You will need the following:

An exact step-by-step plan of the entire due diligence exercise.
All of the information and relevant items you need from the seller before you start the analysis.
A checklist of… (more available to subscribers)

Employee issues

Thorough due diligence should pick up any issues, risks and potential liabilities relating to the seller’s employees. For instance, check if there are any past or present employees litigating against the business. Other important areas to look at might be the following.
Do any of the employment contracts have unusual clauses i.e. over-the-top redundancy packages?
What are the specifics of the pension plans?
What is the bonus structure and is it rewarding performance fairly?
(more available to subscribers)

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. As these are legal documents, which are meant to protect both the buyer and seller from things going wrong, they can be complex, expensive and take time to put together. Focus on major issues first.

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. The buyers must communicate the key issues of concern to their solicitors; they should not just assume that all areas are of equal importance, and that everything will be dealt with in good time. Continually monitor the activity of the solicitors and accountants carrying out your diligence and make sure they are giving you regular feedback.

Don’t forget the culture

Funny how the lack of understanding of the target’s company culture is one of the main reasons for failed acquisitions, yet this has been notoriously ignored in the due diligence process. Don’t make the same mistake. This is usually one for the purchaser’s management to consider, rather than delegating to legal or financial advisers. Map out the management styles of your business and the target business. In the report we look more closely at the culture of a business.

Collect information, then analyse

Don’t 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.
Finally, make sure you differentiate between fact and opinion. Information that is presented as fact should be signed off by the target company’s directors.

Don’t 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, ultimately consuming extra time and costs.

In partnership with the Business Sale Report Smithfield Partners Solicitors and WM ProServ LLP, accountants are offering £5000 worth of free legal or accounting Due Diligence. What is the catch? This offer is only available to the first 5 companies that apply via the Business Sale Report. To qualify you just fill in our due diligence enquiry page.

We wish you luck in finding a great investment for 2010!

At the Business Sale Report we have undertaken a straw poll of the business brokers and other professionals in the small to mid-market M&A industry to see how they thought 2010 would be for the buying and selling of businesses. Subscribers to the report can see who said what. So here are some of the opinions of the movers and shakers in the industry:

“Investors seem to be thinking that 2010 will be an improvement on 2009. People who have access to liquidity are making tentative signs they are willing to invest in the middle of the year when the situation should be clearer. Investors who can be creative when it comes to financing a deal are in a great position.”

“At the moment there appears to be a disconnect between the real business world and how the bankers who are funding businesses are operating. Recently there have been more signs of banks lending but they are only lending to people with a good track record, and also really only looking at one project at a time. However, some banks are lending at 75% debt for equity. The February bank reporting season will be important for the confidence of M&A in 2010. Asset-based businesses and those involved in the Internet I expect to be the best M&A prospects for 2010.”

“The market in businesses valued at between £1m and £2m has seen growth so far in the last quarter. I am therefore very positive about the outlook for 2010. People are looking to sell at the moment and funding is not too difficult for the right deal.”

“I am expecting 2010 to be better than 2009 but the outlook for 2011 is more uncertain as there may be more forced sellers then and prices for businesses will fall.”

“Some businesses are happy to sell assets to strengthen balance sheets. There will always be deals to be done but I envisage more forced sellers. My advice to anyone looking to buy a business in this market is to stick with what you know, as there are good deals to be had.”

“If unemployment hits 3 million then we will be in trouble. There are simply not enough smaller businesses on the market at the moment and demand has outstripped supply for good businesses. People are desperate to buy for turnover, as they want to exit in 5-10 years. People are not coming to the market as they think they will not get a good price. If the business is a good one and there are synergies with the buyer then businesses are selling for decent money.”

“There is no appetite for acquisitions of businesses with a high premium on goodwill. The banks have a policy that they will only lend on the value of goodwill if assets of the same value are used as collateral for the loan. I cannot see a revival of fortunes for engineering businesses for 2010. However I believe that Health and Safety businesses and those involved in the medical sector will be in demand next year.”

“I expect 2010 to be better for buying businesses but we are starting from a very low base. With a low volume of private equity transactions it is hard to gauge how strong the Limited Partnerships will be going into next year, as they haven’t really been tested. An expected change in Government will no doubt cause some uncertainty for the prospects in 2010.”

So there we have it, a mixture of positive and negative sentiment on the prospects for 2010. We certainly agree that any business with a good asset base and with good contracted positive cashflow will be a good prospect. To find out who said what, you will need to subscribe to the report. We believe that 2010 will be a good opportunity for buying businesses as long as you know exactly what you are doing as mistakes will be very costly. Make sure you have done good due diligence, have a good relationship with your funding partners and be ready to move quickly.

During the third quarter of 2009 the Private Company Price Index (PCPI), which gives an indication of the average multiple of after tax profits at which private firms are sold for, rose again – much to the delight of anyone looking to sell a business. This is the second quarter in a row that we have seen rising multiples being paid. Please see our previous blog on business valuations rising posted in October.

Although merger and acquisition activity declined in the third quarter, for the seventh consecutive period, the multiples of profits at which business for sale are being sold for increased by 5 per cent. With the 5 per cent rise, people selling businesses were achieving an average of 11.7 times their historic after-tax profit. Of course, it should be noted that these figures relate to announced deals which have an average deal size of £15m. Smaller businesses multiples are lower overall to reflect the increased risk but if you wish to have a guide on the possible value of your business then please feel free to fill out our form for a no obligation business valuation

In addition to improvements in the PCPI, the Private Equity Price Index (PEPI), which tracks the multiples of profits that businesses sold to private equity achieve, also reported good news, rising 4 per cent to 12.3 times.

The continuing slow M&A market can be partly blamed on a more restrictive lending policies, particularly within the leveraged buyout market. This is reported to have offset the benefits an increase in corporate bank debt available to people wanting to buy a business for sale.

The increase in confidence among the corporate finance community has helped to boost the amount of money companies are being sold for. In addition, the number of exit reviews, proposals and pitches is increasing in response to a change in sentiment among business vendors. Many are realising that income and capital gains tax increases will catch up with them next year and that selling a business takes several months to complete – leading to an increase in the number of business being put on the market.

Business Sale Report has seen a 20 per cent increase in listings in the past quarter! To contact the sellers of these businesses then please subscribe.

A look at the current state of the M&A market for small and medium sized businesses

Up until this summer, the small to mid-sized business M&A market has not been severely affected by the problems in the financial markets. However, as the general lack of confidence continues and lending remains very scarce it is now no longer immune. The almost complete lack of IPO’s on both the main market and AIM, has meant a reduced number of businesses raising cash for acquisitions. Consequently, this has significantly reduced the total number of transactions being done.

On current deal values, Marc Fecher from Devonshire Corporate Finance comments: �there has been pressure on prices, mainly due to the EBIT multiples that banks are prepared to lend on coming down. Before the credit crunch last summer, it was common for banks to lend up to
five times EBIT. This figure is now more like two to two and a half times.� However, the landscape is constantly changing and this is reflected, and could be argued is caused by, the large fluctuations in the stock markets. In addition, the reactive and unprecedented course of government and monetary policy has had a major part to play. The result is that it has become virtually impossible to forecast what is going to happen in any real time frame.

For nervous buyers or sellers nearing the completion of a transaction, advisors are finding it difficult to say with certainty whether their clients are sitting on a good deal. Instead they are trying to ensure that their clients remain fully informed and are aware they are taking on perhaps more risk than would have been the case twelve months ago.
However, there are still many reasons why entrepreneurs should still maintain their acquisition focus: people will always want to retire; owners will always have health issues; companies will need to find ways of solving problems and being bought is one of them.

So who is out there buying?

Trade buyers are still in the market looking to make strategic purchases. They are looking at new markets, higher return on capital, have a need to diversify and/or have cash cow businesses that need to reinvest and expand.
With regard to financial buyers there is understandably much uncertainty and many private equity funds are turning themselves into cash. However, they will come back into the market in time. Private equity funds have been unable to raise the same level of debt as previously. Some private equity buyers are providing their own underwriting facility to insure the financing. However, this all costs money.
Currently the best buyer in the market is the consolidator or platform builder who wishes to take advantage of the fragmented market in its sector. Recent purchases such as Melorio acquisition of Zenos, the Oxfordshire-based provider of vocational training services to the IT sector with 116 staff, for an initial �21m is one example.

When buying or selling a business, there is frequently a gap between the seller�s perception of the business�s potential worth and the price a purchaser is prepared to pay based on actual performance. One way of addressing this is to include an earn-out as part of the deal. In this situation, the purchaser will typically pay 60-80% of the asking price upfront, with the remaining 20-40% to be paid subject to the company achieving performance targets agreed by both parties within a designated period.

This type of deal works particularly well for businesses where there is a high degree of uncertainty about the future. These include high growth/new companies, companies with unproven new technologies or artistic/creative assets. It is also a good option when a company is overly dependent on the owner or other human assets, as in the case of many recruitment or other service businesses, since the seller is then financially committed to ensuring that goodwill and key staff remain with the business.

When is an earn-out appropriate?
Firstly, in order for an earn-out to be successful, all the owners of the business must have a desire to stay on and assume a significant amount of responsibility for the running of it. Any business where there are sleeping partners (for example, part-ownership by private equity) is unlikely to be suitable, as there will undoubtedly be conflict between those who want to receive as much as possible upon completion and those who want to maximise the earn-out. The buyer should also be prepared to keep the acquired company�s operations separate from any existing businesses, as otherwise it will be difficult to gauge its performance in relation to the targets set. Therefore, any sale where the business is to be quickly integrated into the buyer�s existing business is generally not suitable for an earn-out.

Structuring the deal
Perhaps the most difficult element of an earn-out transaction is deciding how the business is to be run post-acquisition. The agreement must be a compromise between the seller, who wants to remain at the helm of the business so as to maximise profits and ensure that the targets relating to the earn-out payments are met, and the buyer, who will want the freedom to act in the interests of the whole company when making key decisions (such as pursue new business opportunities), without interference from the seller.

When negotiating the deal, the seller should seek to keep as much control as possible over the assets and the budget, the hiring and training of staff and any marketing and sales strategies. It is worth considering including a clause in the contract penalising the buyer if the agreed rules are not adhered to, as well as an acceleration or modification of the earn-out payment if the circumstances of the buyer�s business change (such as a sale of the business or any assets within it). It may also be possible to guarantee a minimum payment for the earn-out.

Setting the right targets
While it is easy to assume that it is in the buyer�s interests to set the threshold as high as possible for deferred payments, unrealistic targets can destroy staff morale within the business and impact upon performance. As well as setting achievable targets, both buyer and seller need to offer incentives to key members of staff. The buyer can do this through stock options or performance bonuses, while the seller should consider allocating a portion of the earn-out to reward high-performing staff.

It is also important to establish exactly how performance is to be measured within the terms of agreement. This should include the way in which the accounts will be drawn up, the treatment of any management or central charges, the cost of funding and the availability of resources for business opportunities, etc. Basing payments on gross rather than net revenues can simplify the process considerably, and avoid potential disputes over the way profits are calculated, however if you are the buyer it may be better to use net earnings, which have more flexibility and better reflect the business�s true performance. You may also consider using other methods to determine performance, such as cash-flow or even the generation of new business.

Timing
Setting the timescale for the payments is a key factor in determining the success of the deal. This needs to be long enough for the buyer to ensure that the seller will invest in the business�s future rather than focus on purely short term gain, while from the seller�s point of view the risk of reaching the agreed targets increases the further away those targets are. As a general guide, it is best to structure the earn-out over two or three years, with interim payments. Also agree on the method of payment for any settlements � if you opt for cash, this is likely to have tax implications.

Finally, it is worth being aware of other options that can provide useful alternatives to an earn-out if the seller wishes to remain with the business. These include taking shares in the acquirer as part of the deal, converting the earn-out into a royalty agreement, or simply remaining with the business as an employee, receiving a salary and bonus payments.

Conclusion
When structured properly and applied in the appropriate circumstances, an earn-out can be a �win-win� situation for both buyer and seller. The seller will be financially rewarded for the anticipated future value of the business, while the buyer avoids overpaying for untested potential and ensures that the seller remains motivated during the handover period. If the targets for the earn-out are met, the seller receives an excellent price for his business (the sum paid out from the deferred part of the deal can in some cases be more than the initial amount received at completion), while the buyer is happy to pay the consideration, as he is now the owner of a highly profitable and valuable business. However, the flip side of this is that earn-outs are complex transactions that carry a significant �unknown� element for both parties, and there are many pitfalls that can lead to disaster if the terms of the deal are poorly set out.