Caveat Emptor - Dangers of buying a business

There are many purchasing pitfalls that can trap the unwary. People sell their homes for a range of obvious reasons, and they renew their cars regularly, but the promptings for selling a business are less apparent, unless there is something wrong. It is important to remember that there are few absolute bargains. If a business is going cheap, there is probably a good reason. Never forget that the seller knows a lot more about the business than the buyer.

Buyer beware

There are a number of signs that might indicate that a business is in difficulties. These can include reduced recruitment and training activity, delay of planned maintenance, missing a major trade show, closure of product or quality development teams and reduced investment in tooling or software. There is a fashionable term - preparing businesses for sale - which can be a euphemism for simply ceasing any expenditure connected with the future.

There was one well documented fraud where the due diligence ticked all the boxes, but the vendors had hired in a number of work experience staff to make the factory look busier while the investigators were on site.

Having got a fix on the strategic issues, the next step is to examine the profits record to pick out any adjustments.

A key point to note is the significance of most SME's being audit exempt, so that provisions for stock obsolescence or doubtful debts might not have been consistently treated in the past. Purchasers should have warranties to protect themselves, but it is much better to avoid expensive litigation after the deal by getting the price right in the first place. Litigation has shown that the auditors in larger companies, in any case, have no duty of care towards potential acquirers.

Arriving at the adjusted net profit

There are essentially two main types of adjustments that need to be made:

Allowances for non-recurring items, such as a grant or a big debt

Items shown as costs that are really a distribution to the current owners.

For example, distributions to owners might be special pension contributions, or expenses that are a consequence of the life style of the shareholders, as well as the usual salaries and benefits in kind. In one instance a US business was in the process of buying a company in South Wales, unfortunately the vendor had forgotten that he had put his Cardiff Arms Park debenture through the company - Once the purchaser understood the importance of being able to take customers to the match, the vendor had to buy his own tickets.

Where a company occupies its own freehold property it may also be necessary to adjust the trading results for a notional rent charge, if the property is worth substantially more than its book value.

Standardising earnings
The purpose of restating results is to show what the earnings of the business would have been on a standardised basis, as a guide to the future earnings. The valuation exercise is done therefore to establish how much a theoretical buyer would be prepared to pay as a capital sum in exchange for the right to receive those future earnings.

Earnings for this purpose would be trading profits before interest but after a notional taxation charge. This recognises that the value of the business may be different from the value of the equity, as the latter value will depend on how the business has been financed. Where businesses have accumulated cash reserves it should be remembered that these funds represent past earnings which have not been distributed.

Valuing the business

Once the true earnings of a business has been established and a judgement made as to what the future earnings are likely to be, the next step is to look at what the business is worth.

There are many methods of valuation and we go into this in greater detail on our blog and the resources section of our website. Generally the main methods are the following

Comparison based valuations

Price earnings ratio basis of valuation

Discounted cash flow and the internal rate of return

Net asset value and goodwill

However the PE ratio or multiplier method is the most commonly used for businesses in the £500k to £10m range. The multiplier effectively determines how many years' earnings a buyer would be prepared to pay for.

The selection of the multiplier and the discount requires the exercise of some judgement, and can be influenced by how well the company is managed, its growth record and the impact of any contracts. A crucial understanding is needed of the customer base, how widely this is spread and the volatility of customer spending patterns. A standard multiple is often arrived at by the buyers adviser based on comparative transactions and the advisers knowledge of what the rate of return / pay back period that prospective buyers are prepared to accept. This can then be adjusted according to the probability that the earnings will rise or fall.

In the case of 10 million pound plus businesses, a starting point might be the equivalent PLC ratio for businesses in that sector. The next step would be to discount the multiplier, because the private company status usually carries with it restrictions on the marketability of the shares.

Valuing a business based on cash generation
An alternative method is to examine the cash that the business generates, which is less prone to accountancy judgement than profits. This is done by stating the EBITDA or earnings before interest, taxation, depreciation and amortisation.

Where the purchasers need to incur debt to make the acquisition, it is likely that their funders will restrict the level of EBITDA multiplier in a deal they are prepared to support; this is because there must be enough cash flow to support each of the three legs of the 'milking stool'. The first leg is the ability to fund the payment to the vendors, the second leg is to be able to fund whatever reorganisation costs are needed to make the acquisition successful and the third leg is to fund the working capital. If there is not going to be enough cash flow to fund all three legs, then the thing falls over.

This is the main reason why vendors' aspirations as to price are rarely met, unless the sale is to a trade buyer who can pay more because they can use cash resources without funder approval.

Special thanks to Nick Pritchard of Transaxman ltd. For details of transaxman services please refer to his website here

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