Maximising Value on the Sale of a Business (Hawksmere Report)

M

MAXIMISING VALUE ON THE SALE OF A BUSINESS – strategic and financial techniques

Peter Gray

A Hawksmere Report published by Thorogood

IFC

A Hawksmere Report

MAXIMISING VALUE ON THE SALE OF A BUSINESS – strategic and financial techniques

Peter Gray

published by Thorogood Ltd

Published by Thorogood Limited Other Hawksmere Reports published by Thorogood: Legal Liabilities for Insurers Fred Collins

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The author Peter Gray Peter graduated with degrees in Law and Commerce from Melbourne University in 1984. He joined the Corporate Finance Department of Minter Ellison,a leading Australian law firm, where he qualified as a lawyer. In 1989 Peter joined the corporate finance group of Clifford Chance in London. He worked on a wide variety of transactions including management buy-outs, stock market flotations and acquisitions and disposals. After completing an MBA in Finance at City University, Peter joined Cavendish Corporate Finance in 1994 and was appointed as a Director of Cavendish in 1997. Peter is a frequent author and lecturer on the subject of mergers and acquisitions.

Contents Introduction......................................................................................1

1

MARKET OVERVIEW

Review of M&A activity ....................................................................3 Drivers of the M&A market...............................................................3 The late 1980s revisited?...................................................................6

2

MAKING THE DECISION TO SELL

Reviewing the alternatives................................................................8 Reviewing the shareholders’ objectives............................................9 Reasons for sale ..............................................................................10 Getting the timing right..................................................................11

CONTENTS

3 4

OVERVIEW OF THE SALE PROCESS

Informal auction .............................................................................15 Formal auction................................................................................16

GROOMING A BUSINESS FOR SALE

Introduction....................................................................................18 Financial matters.............................................................................18 Operational matters ........................................................................20 Legal review....................................................................................21 Other matters..................................................................................22 Vendor due diligence ......................................................................23 Conclusion......................................................................................23

5

TAX PLANNING

Introduction....................................................................................25 Your sleeping partner – with a 40% profit share ............................25 Retirement relief – while stocks last...............................................27 Re-investing the proceeds...............................................................27 Share exchange ...............................................................................27 Emigration.......................................................................................28 Offshore trusts ................................................................................28 Timing.............................................................................................29 Mix ‘n’ match...................................................................................29 Conclusion......................................................................................30

CONTENTS

6

VALUATION TECHNIQUES

Introduction....................................................................................32 Types of valuation techniques ........................................................33 Case study .......................................................................................34 Illustration ......................................................................................36 Other valuation techniques ............................................................39 Relationship between size and price..............................................40 Conclusion......................................................................................41

7

APPOINTING ADVISORS

Selecting a financial advisor ...........................................................43 Appointing legal advisors ..............................................................46 Appointing tax advisors .................................................................46

8

PREPARING AN INFORMATION MEMORANDUM

Objective of an information memorandum ....................................49 Contents of the memorandum........................................................49

CONTENTS

9

IDENTIFYING POTENTIAL PURCHASERS

Identifying the optimal purchaser ..................................................52 Types of potential purchasers.........................................................53 Conclusion......................................................................................58

10

APPROACHING POTENTIAL PURCHASERS

Formal versus informal auction .....................................................60 Staggering approaches ...................................................................61 Dealing with unsolicited offers ......................................................61 Contacting potential purchasers ....................................................61 Maintaining confidentiality ............................................................62

11

THE NEGOTIATION PROCESS

Introduction ...................................................................................65 Understanding the purchaser’s objectives .....................................65 Releasing information ....................................................................65 Bridging the price expectations gap – earn outs ...........................66 Reviewing offers ............................................................................67 Heads of agreement .......................................................................68 Rules for successful negotiation ....................................................71

CONTENTS

12

THE DUE DILIGENCE PROCESS AND WARRANTIES

Introduction ...................................................................................73 Types of due diligence ...................................................................73 Warranties ......................................................................................75

13

CONCLUSION

Key rules .........................................................................................77 Bibliography....................................................................................78

Introduction Selling a business is one of the most important and stressful events in the life of any proprietor of a private company.There can never be any guarantee of success once a sale exercise is undertaken.Embarking on a sale may involve the business incurring significant costs and unexpected risks and disruption.For example,there may be a breach of confidentiality which can be harmful to the business. It is therefore advisable not to undertake a sale exercise lightly, or simply for the purposes of ascertaining the value of the business. Careful consideration of the procedures outlined in this report will help to minimise the risks and maximise the chances of achieving a successful sale of a business. This report is primarily concerned with the sale of privately owned businesses, which are frequently family concerns. However, it also considers issues faced by quoted companies selling subsidiaries and institutional investors selling investee companies. We commence with an overview of the current market for mergers and acquisitions and examine some of the influences on M&A activity.There then follows an analysis of the procedures involved in selling private companies and the means by which a vendor of a private company can maximise value on a sale of his business.

1

Market overview REVIEW OF M&A ACTIVITY DRIVERS OF THE M&A MARKET T H E L AT E 1 9 8 0 S R E V I S I T E D ?

chapter

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Chapter 1: Market overview

Review of M&A activity 1998 was another record year for M&A activity in the private company sector. The value of recorded private company sales in the UK last year was £22 billion. This surpassed the previous record year of 1996 when the total deal value was £20.2 billion and contrasts with a comparable figure for 1993, when private company sales of a ‘mere’ £4.5 billion were recorded. In terms of activity levels, the picture is somewhat different with 1988 retaining the record for the highest number of private company sales at 1,475 compared to a figure of 1,298 for 1998. The big difference between then and now is that the average value of deals has increased dramatically from £3.6 million in 1988 to approximately £17 million in 1998.One reason for this is the recent spate of building society and life company take-overs which, for the purposes of M&A tables, are categorised as private company sales. Prices being paid for private companies have also increased in recent years with the private company price index standing at an historically high level.What has driven the market to record levels over the past few years? The answer lies in a combination of factors.

Drivers of the M&A market First, corporate profitability has generally been extremely strong. This is significant for two reasons.First,it means that private companies can demonstrate to potential purchasers a solid track record of profits since the end of the last recession. Secondly, it has meant that listed companies have been cash rich and have the financial capability to make acquisitions. Interestingly, corporate profitability can operate in different ways. For example, in the oil exploration sector, the impact of the weak oil price on profitability has resulted in a spate of mergers amongst major oil companies in an effort to reduce costs. Similarly, the weakness of UK engineering companies has resulted in a number of take-overs in that sector as US groups, in particular, snap up their weaker UK counterparts.

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The strong stock market has also assisted listed companies by facilitating equity fund raisings. Moreover, the fact that listed companies are trading on relatively high price earnings ratios has enabled them to pay higher prices for private companies while still generating a positive effect on their earnings per share. Perhaps the most important factor fuelling the boom in private company acquisitions over the past few years has been the liquidity of venture capital funds.Their ability to make acquisitions has been helped by low interest rates and the ready availability of bank finance. In 1998,venture capital firms invested a record £11.4 billion in management buyouts and buy-ins.The amount of funds available for investment in venture capital funds is at an all time high and the intense competition to find a home for these funds has meant that,in many cases,venture capital houses have been significantly outbidding trade buyers. The continuing trend for quoted companies to focus on core activities and to dispose of all non-core businesses has made a significant contribution to M&A activity levels. Disposals of non-core operations has particularly fuelled the growth of the MBO market. Privatisations and demutualisations have also played their part.A higher proportion of the utilities privatised in the early 1990s have now been taken over.The past couple of years have also witnessed a number of large acquisitions of building societies and other mutual organisations, including the recent acquisition of the RAC by Lex Services. Another major contributory factor in the current M&A boom is the trend towards consolidation and globalisation across a broad range of sectors.These include financial services,advertising,automotive,telecoms and the pharmaceutical sector. In many cases, consolidation is customer led. For instance, in the case of consolidation amongst automotive suppliers, the need for car manufacturers to have suppliers who can support their operations on a global basis is driving mergers in that sector.In other cases,such as pharmaceuticals it is the imperative for global distribution and R&D economies which is driving consolidation. There is every reason to believe that consolidation across a number of sectors will be an ongoing process which will underpin M&A activity levels into the foreseeable future, regardless of the state of the underlying economy.

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M&A tables The following charts show the volume and value of mergers and acquisitions activity over the last eleven years broken down between public company bids, divestments of subsidiaries or divisions of quoted companies and private company sales.The table shows M&A activity slumping during the recession of the early 1990s from the cyclical peak in 1988/89 and then recovering strongly over the last five years in line with economic growth. One word of warning about the numbers. The Acquisitions Monthly tables do not pick up very small deals and therefore the number of deals is inevitably understated and the average value overstated to some extent.

UK mergers and acquisition activity by volume 1988-1998 2500

Number of deals

2000

1500

1000

500

0 1988

1989

1990

UK public companies

1991

1992

1993

1994

UK private companies

1995

1996

1997

1998

UK divestments

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UK mergers and acquisition activity by value 1988-1998 100,000 90,000

Number of deals

80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 1988

1989

1990

1991

UK public companies

1992

1993

1994

UK private companies

1995

1996

1997

1998

UK divestments

The late 1980s revisited? Are we back to the halcyon M&A days of the late 1980s? Although current activity levels are broadly comparable with those prevailing in 1988-89,there have been significant changes in the market place since that time. For example, acquisition strategies are now far more focused. By and large, UK companies are focusing on core activities having learnt the lessons from the disastrous diversification strategies of the 1980s. The days when advertising agencies made bids for banks have now long since passed. The 1990s have witnessed the death knell of the large,unfocused conglomerates established during the 1980s with companies such as Hanson and BTR either demerging or falling prey to leaner and more focused competitors. Due diligence is also much more thorough than it once was.Again,the days when deals were struck on the basis of a handshake and some numbers scrawled on the back of an envelope are a relic of the 1980s. In short, the M&A market over the past few years has been a far more sober affair than the M&A frenzy of the late 1980s.

6

Making the decision to sell R E V I E W I N G T H E A LT E R N A T I V E S REVIEWING THE SHAREHOLDERS’ OBJECTIVES REASONS FOR SALE GETTING THE TIMING RIGHT

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Chapter 2: Making the decision to sell

Reviewing the alternatives The first task for someone considering a sale of their business is to determine their objectives, both financial and otherwise, and then to determine whether those objectives are likely to be achieved by selling the business. A sale may be inappropriate or simply not possible for a number of reasons. It may be that a sale is not a viable option,because the business is totally dependent on one person.Alternatively, the company may operate in an industry which is in terminal decline.A case in point was Alpha Airports abortive attempt to sell its duty free operation in 1998 coinciding with the potential abolition of duty free sales within the European Community.Even where a sale might be appropriate at some stage, it may not be the optimal time to sell.The growth profile and the current size of the business may dictate that the sale should be deferred. There are a number of different exit routes for a proprietor seeking to realise value for his business.These include a sale of 100% of the shares in the company, a partial sale of some of the equity or a stock market flotation. In the majority of cases, not all of these options will be available. For example, a company may be too small or may not have a sufficient track record of profits for a flotation.

Caution

Objectives

Type of Exit

Cash Out/Early Retirement

Trade Sale/ MBO/Financial Purchase

Part Cash Out/ Retention of Equity

Partial sale to venture capitalists or strategic buyer Sale with long earnout

Ambition

No Cash Out Capital Growth

Flotation/growth capital

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Where there is a choice of exit routes, the objectives of the proprietor will determine which of these exit routes represents the best alternative.Where the owner wishes to retire and realise cash for his shareholding, a sale of 100% of the business is the only viable option. If, on the other hand, the proprietor is relatively young,wishes to remain with the business and has little or no immediate need for cash, a flotation may be the preferred choice.Alternatively, a proprietor may wish to realise part of the equity in his business by way of a partial sale but retain the balance for an exit in the future.

Reviewing the shareholders’ objectives Consideration of the objectives of the shareholders is especially important where there are several shareholders having different agendas which may give rise to potential conflicts of interest.As far as possible, the exit strategy chosen must fit with the needs of all interested parties, including members of the management team who are not shareholders of the business. Examples of conflicts between shareholders include: •

some shareholders may seek the entire consideration up front on completion, while others may be looking to achieve a higher price through deferred consideration,or an earn-out.Alternatively,some may be prepared to take shares in the purchaser, while others may not;

•

some shareholders, who are also directors or employees, may seek a purchaser who will enhance their careers and employment prospects;

•

where there is an institutional shareholder as well as management shareholders,the institution will not be prepared to give warranties but will expect the management to do so.

In some cases,the shareholders will enter into a formal memorandum in advance of the sale which covers issues such as the minimum price expectation, preparedness to remain with the business following a sale, willingness to give warranties to the purchaser and the type of consideration which is acceptable. This can be an extremely useful exercise in flushing out issues prior to the sale. Disagreement between shareholders once the sale process is underway needs to be avoided at all costs.

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Reasons for sale The most frequent reason given for considering a sale is the desire to realise capital, either for financial security or new projects. There is, however, rarely one reason alone, but generally a combination of the following: •

the recognition that the business has reached a premium value;

•

the realisation that the business cannot grow without a significant capital injection;

•

the need to access new markets by being part of a large, possibly international, group;

•

the business has reached a size where the owner feels unable or unwilling to manage it;

•

a disagreement among shareholders which means that the business is no longer manageable under existing ownership;

•

a perceived boom in the sector has resulted in high valuations,or there are concerns that a downturn is likely to arrive in the foreseeable future;

•

the only alternatives are closure or sale by an administrator,receiver or liquidator; or

•

an imminent retirement/succession problem.

For a group of companies possible reasons for the sale of a business include: •

the business may no longer fit within the group’s core activities or future strategies;

•

the business may have been a poor acquisition;

•

the group may have to sell because of liquidity problems.

External factors In addition to company specific factors, there are a number of external factors which may have a bearing on the optimal time to sell.These include: •

the acquisition strategies of major players in the sector and/or consolidation patterns that may be emerging.Current examples of M&A bubbles in specific industry sectors include the travel industry and the internet;

•

changes in technology;

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•

the state of the economy and, in particular, the stage of the economic cycle;

•

changes in market conditions;

•

recent or impending legislation affecting the business;

•

the strength of the Stock Market.

SELL

It is important that a vendor is not coy about the reasons for sale. It will usually be one of the first questions asked by a potential purchaser and a reluctance to answer the question may make the purchaser suspicious.

Getting the timing right In common with the sale of any investment, it is extremely difficult to pick the optimum time to sell a business.However,there are some general rules in timing a sale which should always be followed.

Recent profits A purchaser will find a three year profit history much more convincing than a three year profit forecast. Unless you are operating in the IT or telecoms sector, it is important to have a good profit track record to show potential purchasers.

Year end Planning a sale exercise to complete shortly after a financial year end will allow the sale to be based on an audited set of accounts.This will reduce uncertainty over the profits on which the purchase price is based and the assets being sold. Furthermore, it means that the vendor is able to provide financial warranties to the purchaser based on a recently audited set of accounts and thereby transfer some of the risk for a breach of the accounts warranties to the auditors. A further advantage is that due diligence by the purchaser’s accountants can take place simultaneously with the year end audit, thereby minimising disruption to the business and helping to maintain confidentiality.Lastly,some purchasers may wish to have an input into the finalisation of the accounts, for example, by creating provisions for release in future periods to enhance the profits of the company in the period following the sale.

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Tax reliefs The current tax regime is always a relevant consideration in timing a disposal. For example, the system of taper relief introduced in the 1998 budget for owner managers may influence some vendors to defer a sale to minimise their exposure to capital gains tax.

The golden rule The one overriding rule in timing the sale of a business is to always sell at a time when there is no absolute need to do so. Buyers will quickly sense a forced sale and use that knowledge to their advantage.

Timescale

Management time commitment

Determining the optimum time to start a sale exercise will be influenced by the following timetable which can be used as a rough guide.The timetable also shows the demands on management time which a typical sale exercise will impose.

Commerce marketing

Receive indicative

Due diligence

Exchange and completion

offers

No. of months 0

1

Advisors appointed

Information memorandum

2

potential purchaser list prepared

3

4

Initial meetings with potential purchasers

Draft heads of agreement

5

6

On average, a sale exercise can be expected to take around six to seven months. However,this is only a rough guide.It can take considerably longer but will rarely be significantly shorter, except in the case of a distressed sale.

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Overview of the sale process INFORMAL AUCTION FORMAL AUCTION

chapter

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Chapter 3: Overview of the sale process The sale process can be divided into two distinct stages, the pre-sale stage, and the sale itself. Both are equally important. The pre-sale period involves making the decision to sell,getting advisors on board and preparing the business for sale.The sale process itself involves the preparation of an information memorandum,simultaneously with compiling a list of potential purchasers for the business.Approaches are then made to potential purchasers which will hopefully lead to a number of offers for the company.Once these initial offers have been negotiated upwards to the maximum extent,a preferred bidder is chosen and given a period of exclusivity in which to conduct due diligence and to prepare the necessary legal documentation. This process varies to some extent depending on whether it is determined to run a formal auction or to conduct a less formal approach.The decision on which route to pursue and the differences between the two approaches are examined in greater detail in Chapter 11. The two approaches are shown diagrammatically on the following two pages.

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Informal auction

Pre-sale period:

Initial assessment

Sale process:

Prepare information

Choosing advisors

Review of alternatives

Pre-sale grooming

Identify purchasers

Contact purchasers

Confidentiality letters

Hold off-site meetings

Obtain indicative offers

Arrange site visits

Negotiations

Heads of agreement

Due diligence

Legal contracts

Legal completion

Deal structures

Exclusivity

Forms of consideration

Conditions

Timetable

Control information flow

Warranties and indemnities disclosure letter

Public announcements

Service contracts

Net asset adjustment

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Formal auction

Pre-sale period:

Initial assessment

Sale process:

Prepare information memorandum

Choosing advisors

Review of alternatives

Vendor due diligence

Pre-sale grooming

Timetable

Identify purchasers

Contact purchasers

Confidentiality letters

Preliminary offers

Shortlist purchasers

Due diligence

Final offers

Preferred bidder

Further due diligence

Legal contracts

Legal completion

Management presentations, site visits, data room, DD Report, contract

Deal structures

Exclusivity

Forms of consideration

Conditions

Control information flow

Vendor DD assigned to purchaser

Warranties and indemnities disclosure letter

Public announcements

Service contracts

Net asset adjustment

16

Grooming a business for sale INTRODUCTION F I N A N C I A L M AT T E R S O P E R AT I O N A L M AT T E R S LEGAL REVIEW O T H E R M AT T E R S VENDOR DUE DILIGENCE CONCLUSION

chapter

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Chapter 4: Grooming a business for sale

Introduction It will never be possible to maximise the proceeds of a company sale unless time is taken before the sale commences to prepare the business for sale. A grooming exercise, which can take place over a few months or even years before a sale exercise,aims to enhance the attractiveness and value of the business to potential purchasers.This is achieved by measures such as: •

maximising recurring profits by reducing or stopping proprietorial or non-business expenses;

•

improving margins by reconsidering proposed ‘non-essential’ expenditure on marketing, R & D, etc or by raising prices;

•

without compromising the above, maximising sustainable sales levels;

•

ensuring the balance sheet is clean,e.g.by removing non-business assets;

•

where possible,securing long term beneficial contractual relationships.

A review of the business to determine appropriate pre-sale grooming measures should cover the following areas:

Financial matters Margins review Whilst a business may historically have priced its products with its long-term future in mind,and,in particular,to deter potential entrants,in a situation where a business enjoys some degree of market power, research could be undertaken to see if a period of higher prices could be sustained in the lead up to a sale.

Review of costs A review should be undertaken to identify and eliminate all proprietorial costs which would not be incurred by an incoming purchaser.These would include

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relatives on the payroll or excessive travel and entertainment costs incurred by the proprietors.Whilst a purchaser might be persuaded that these costs should be added back to determine the company’s underlying profit, the argument is always stronger if the business can be run for a period with these costs removed.

Assets review When a business has assets which may not be required or fully valued by a purchaser,such as surplus property,investments,or indeed,surplus cash,removal before a sale exercise commences should be considered. To enable a pre-sale dividend to be paid, liquidity should be maximised and working capital reduced to the minimum level required to generate the company’s profit stream.Policies concerning stock holding levels,debtors,and creditors should therefore be reviewed at an early stage to ensure that there is no ‘fat’ in working capital.If the company is sold with excess stocks or,due to poor credit collection, excess levels of debtors,the vendor is,in effect,gifting the surplus to the purchaser. Any such surplus should be eliminated and the resultant cash either stripped out or added to the purchase price. Any hidden or undervalued assets of the business should also be identified.If the value of property assets is understated in the company’s balance sheet relative to their market value, they should be re-valued independently prior to a sale.

Tax review All PAYE,VAT and corporate tax matters should be up to date.Tax allowances, if appropriate,should be maximised,and tax computations agreed with the Inland Revenue.Any tax losses available to be carried forward should be identified.

Pension schemes It is extremely difficult for a vendor to obtain full value from a purchaser for a surplus in a final salary pension scheme. It is therefore advisable for a vendor to eliminate the surplus in the lead up to a sale by taking a full or partial pension holiday. Better still, if the vendor avoids final salary schemes completely in favour of defined contribution schemes,as the former can give rise to enormous valuation issues on a sale.

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Operational matters Management review The quality of the company’s management team will generally be of paramount importance to a purchaser,especially where the owner/managers are proposing to leave the business at the time of, or shortly after, a sale. It is important to be able to convince the purchaser that there are competent second tier management available to assume executive control of the business.This will involve devolution of management control by the owners in the lead up to a sale,where second line management are taking executive decisions, this should be documented. For evidentiary purposes, it may help to recognise their input formally by: •

minuting management meetings;

•

issuing formal job descriptions; and/or

•

considering job titles and reviewing organisational structures.

Purchasers attach considerable weight to job titles. For that reason, promotion of senior management to the Board of Directors in advance of a sale will make it easier to convince a purchaser that there will be a self-sufficient management team in place following their departure. It might also help for the owner/managers to take an extended holiday before the sale to show the purchaser that the business can operate effectively in their absence. Most purchasers will also require comfort that management support the idea of a trade sale and vendors may want to take early soundings to gauge how co-operative management will be.This might spark management to consider an MBO. To ensure that there is not a mass exodus of senior management following a sale, most purchasers will wish to see key management secured with service contracts. These should be issued in a form which is likely to be compatible with a larger organisation.

Staffing review Any redundancies made once negotiations with a third party have commenced will normally be treated as unfair dismissal by an industrial tribunal.Accordingly, staffing levels should be reviewed before the sale exercise starts. Staff who would not be required by a purchaser might be employed elsewhere in a group or directly by the proprietor, as appropriate.

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Accounting policies review With a sale exercise in mind, a review should be undertaken of the following accounting policies, with a view to maximising stated earnings: •

recognition of profit, particularly for contract related businesses;

•

depreciation policies, both for tangible and intangible assets;

•

provisions – excessive provisions against stock or even debtors is one of the most commonly used techniques to reduce tax. In the lead up to a sale,excess provisions should be released to boost both profits and asset values, preferably over more than one accounting period;

•

valuations of properties and investments;

•

research and development – this may play a large part in the purchaser’s interest in a private company. Small companies are frequently bought for their innovative skills and product development capabilities.Where all research and development has been written off in the past,this should be identified and highlighted; and

•

accounting treatment of any rent free lease agreements.

Accounting systems It is essential for the vendor to start preparing monthly management accounts if he does not already do so. During a sale process, it is vital to have up-to-date information on the current trading performance of the company and purchasers will be looking for the vendor to warrant a recent set of management accounts. It is equally important for the company to produce budgets. At a minimum, a purchaser will be looking for profit projections for both the current and the following financial year.If the company has not had a history of producing budgets (and hopefully beating them) any projections produced specifically for the sale exercise may lack credibility.

Legal review A legal audit should be carried out in conjunction with legal advisors and should, at a minimum, ensure that: •

all leases and title deeds are located and reviewed;

•

trading contracts are examined to ensure that no change of control restrictions or prohibitions apply.Such provisions are potential ‘poison pills’ for a purchaser and to the extent possible should be resisted;

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•

intellectual property rights are registered;

•

shareholder agreements and articles are examined to review provisions relating to a sale;

•

Companies House filings are up-to-date,as are board minutes and other statutory documents;

•

any outstanding litigation is cleared up.Even if it is covered by insurance, major litigation can be a deterrent to a purchaser;

•

to the extent possible, the ownership structure of the company is simplified.This may involve buying in minority or joint venture interests. Purchasers value simplicity and complex ownership structures can diminish the attractiveness of a business.

SALE

Other matters Environmental audit Potential environmental liabilities will be a major area of concern for any purchaser. Depending on the nature of his business, it may be appropriate for the vendor to conduct an environmental audit prior to the sale to enable him to identify and remedy any potential problems at an early stage.

Year 2000 compliance The vendor will be required to warrant that the business is year 2000 compliant and should therefore ensure that computer systems are compliant in the period leading up to a sale.

PR Potential purchasers are much more amenable to a company they have heard of than one whose name they don’t recognise.It is often advisable therefore to raise the company’s profile prior to a sale, by conducting a PR campaign directed not at the company’s customer base but at potential buyers of the business. Examples of profile PR of this nature include obtaining editorial coverage on the company in trade or financial publications.

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Vendor due diligence Vendor due diligence involves the proprietor instructing accountants to prepare a due diligence report on the business in advance of a sale exercise being undertaken.The report is then given to potential purchasers who have expressed serious interest in the company for use in finalising their offers for the business. The main advantage of vendor due diligence is to flush out financial,tax and other issues relating to the business at the outset of the sale process.As a result, the chances of the deal collapsing once Heads of Agreement have been reached, or an agreed bidder chosen,are significantly reduced.It is unlikely that any material issues will arise from the purchaser’s due diligence which had not already been identified in the vendor due diligence report. In addition, vendor due diligence can form a useful part of the grooming process to the extent it identifies issues which can be addressed before the sale exercise is initiated.In choosing an accountant to provide a due diligence report,it is generally advisable to avoid the temptation to use the company’s auditors as this may impact adversely on the credibility of the report. A purchaser will inevitably have some suspicions that the auditor has been ‘lent on’ to provide a favourable report.

Conclusion The more prepared the business is prior to the commencement of the sale process, the greater will be the proceeds of sale. However, it is important not to groom a business for sale in an over-zealous fashion or attempt to boost profits in artificial ways which will be exposed during due diligence.This will back-fire on the vendor and may destroy a relationship of trust established between the vendor and the purchaser. It is also necessary to commence the grooming process long before the sale process gets underway,principally because the impact of the steps taken to enhance profits will take some time to flow through to the company’s accounts.

23

Tax planning INTRODUCTION Y O U R S L E E P I N G PA RT N E R – W I T H A 4 0 % P R O F I T S H A R E RETIREMENT RELIEF – WHILE STOCKS LAST RE-INVESTING THE PROCEEDS SHARE EXCHANGE E M I G R AT I O N OFFSHORE TRUSTS TIMING M I X ‘ N ’ M AT C H CONCLUSION

chapter

5

Chapter 5: Tax planning

Introduction Tax is an important aspect of any business decision. So it is with the decision to sell your company. In this chapter we shall look at: •

how tax affects the decision to sell your business

•

what you can do to reduce the impact of taxation when you sell.

Your sleeping partner – with a 40% profit share When your company is profitable you pay tax on those profits.When you draw a salary or bonus or dividend you pay tax on what you draw.You might think that when you come to sell your business you will already have paid your fair share of tax. How wrong you would be! When you sell your business the taxman does a calculation.He looks at what you got for selling the business. He looks at what the business cost you (in money that is – blood,sweat and tears do not count!).He works out the difference.Broadly speaking he will want 40% of the profit you make when you sell your business. In effect,throughout the years you have been building up your business you have had a sleeping partner. He wakes up when you sell and wants his 40% cut. In the rest of this chapter we shall look briefly at a variety of ways of cutting down the profit share of this sleeping partner.

Cutting the tax rate to 34% We can begin to cut down the Revenue’s profit share by getting the tax rate down from 40% to 34%.This is done using a UK based trust.A trust is an arrangement under which you transfer your shares to someone you trust (called a trustee) to administer for the benefit of people you nominate (called beneficiaries).As we only need a UK trust you can be a trustee and also a beneficiary. You can transfer your shares to the trust free of CGT (unless you have any nonbusiness assets in your company).But trusts have a special rate of tax of only 34%.

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With the help of some financing this tax rate can be used to cut the Revenue’s share of your profit to 34%. This arrangement is comparatively simple to operate. It is wholly UK-based and you get unrestricted use of the proceeds.The disadvantage is the obvious one that it saves only 6% in tax.So let us consider what we can do to cut the problem down even more.

Cutting the tax rate to 25% In the years before you sell your company you might have accumulated profits in the company after paying corporation tax on them. If so, there is nothing to stop you paying out a large dividend immediately before you sell your company. Because of the strange way in which company dividends are taxed you will only pay 25% tax on the cash you draw. You must remember that you can only use this pre-sale dividend route if you have accumulated profits in your company. Company law prevents dividends being paid if the company has not accumulated profits to support them.

Cutting the tax rate to 10% In the 1998 Budget the Chancellor of the Exchequer introduced a new relief called taper relief. It promised the prospect of paying capital gains tax at only 10%.This relief was described at the time as proof there is no mess a government cannot make worse. For the lucky few there is however the real chance of tax at only 10%. Some of the notable drawbacks of this relief are: •

the 10% rate is only available on business assets

•

the relief can be lost very easily for example by giving shares to your children

•

the 10% rate only operates after 10 years’ ownership

•

the 10 year clock did not start until April 1998 – ownership before then only counted as one year however long it actually was.

Cutting the tax rate to zero It is quite possible you do not have accumulated profits in your company to back a large pre-sale dividend.You may not want to wait ten years before you sell your business.So in the remainder of this chapter we look at a variety of ways of getting the tax rate down to nil.

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Retirement relief – while stocks last Retirement relief is a valuable relief for any businessman selling his business. It is, broadly speaking, available to any businessman who is aged over fifty when he sells his business.The maximum relief allowed you to make a gain of £250,000 completely free of tax and only pay 20% tax on the next £750,000.But retirement relief is retiring. It began to fade away in April 1999.Already the maximum relief is no longer available. So it is important to act quickly if you are not to miss out on this valuable relief. If you are selling your business you should get the sale through before the next 5th. April to maximise your retirement relief. But if you are not selling your business you can still act to lock into retirement relief.This can be done by, for example, transferring your business to a company or transferring your shares to a family trust. By doing this you might be able to lock into £500,000 of tax free capital gains.

Re-investing the proceeds Successive governments have used tax allowances and reliefs to promote investment in various types of business activities or even in certain areas of the country. One such relief can be useful when you sell your business. It is called the reinvestment relief or the entrepreneur relief. To get the benefit of this relief you must reinvest the proceeds of your old business in a new one.The new business must be broadly speaking an unquoted UK trading company.There are several types of business that do not qualify and there is a strict time limit.You must make the new investment within three years of selling your old business.As with the other tax planning arrangements mentioned in this chapter, you should take professional advice before you make your investment.

Share exchange When you sell your business you do not have to take cash.You can take shares or loan notes instead. If you do take shares or loan notes the tax on the sale of the business is deferred until you sell the shares or loan notes.You can even write to the Inland Revenue in advance and get a confirmation that you will not have to pay tax until you sell the shares or loan notes.

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But there is a pitfall to avoid.Special,complicated rules apply to certain loan notes called qualifying corporate bonds (QCBs).If the company that buys your business gets into financial trouble you could find the QCBs they have given you are worthless but you would still get a tax bill. So you should be very careful about selling your business and getting a QCB in return.

Emigration CGT only applies to UK resident taxpayers. So you can avoid CGT when you sell your business by going to live abroad.Since the 1998 Budget you must be abroad for at least five complete UK tax years. You must take care if you go abroad to save tax.You must establish tax residence in another country. There have been cases where taxpayers have told the UK authorities they are resident in Spain but have told the Spanish authorities they are only visiting Spain.The tax authorities regularly swap information now and in these cases they both sent tax demands to the taxpayers. The five year rule does not apply if you go to live in a country with which the UK has a double tax treaty.In such a case you might only need to be abroad three years,this opens up the intriguing possibility of Belgium being a tax haven because it has a tax treaty with the UK and quite favourable rules for taxing capital gains.

Offshore trusts We saw earlier in this chapter how a UK trust could be used to cut the tax rate to 34%.We can use an offshore trust to get the benefits of living abroad without you having to leave the UK.As the trust is a separate taxpayer from you it can live abroad instead of you. Offshore trusts have had much publicity in the last decade – from Richard Branson in the early 1990s to certain government ministers in the recent past. In short what an offshore trust provides is a fund of untaxed capital that can be used to benefit you and your family.The ways in which the funds can be used are many and various.They range across: 1.

Simple investments, such as having the money in a bank deposit account and living off the interest;

2.

More complicated investments, such as stocks and shares, unit trusts, insurance bonds and so on;

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The purchase of assets for you and your family to enjoy, such as properties, yachts, helicopters, racing cars, racehorses and so on.

The main disadvantage of using an offshore trust is that your capital is locked up inside the trust. But this problem can be overcome.You might be able to arrange a period of residence outside the UK:if so you could then have access to the capital free of UK tax. Alternatively, it is possible for you simply to sell off the trust for a tax-free lump sum.

Timing As with many business decisions timing is all important in tax planning.The basic rule is that you must complete your tax planning before you have done a deal with a purchaser.This follows from two tax cases in the Courts called Ramsay and Furness v Dawson. Another potentially complicating factor is that the government is proposing to introduce a general anti-avoidance rule.This might enable the Inland Revenue to strike down any tax planning.However,at the time of writing this is only a proposal. It seems no rule will be introduced until 2000 and will in any event only apply to companies. Furthermore the precise scope of any rule is unclear because the Inland Revenue have admitted they cannot come up with a workable definition of tax avoidance!

Mix’n’match It is important to remember that there is not always a single solution to any tax problem. The best answer in any particular case may be a mixture of the techniques outlined above. So, for example: 1.

You could sell your company in exchange for shares and cash in the shares when you are resident outside the UK;

2.

You could sell some shares for cash to use up your retirement relief and put the rest in an offshore trust;

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Conclusion In this chapter we have looked briefly at a variety of ways of saving tax when you sell your business. As with any major business decision you should take professional advice before you embark on any tax planning. But remember the whole point of any tax planning is to keep as much of your money as possible and keep the share of your ‘sleeping partner’ as low as possible.

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Valuation techniques INTRODUCTION T Y P E S O F VA L U AT I O N T E C H N I Q U E S CASE STUDY T H E P R I C E E A R N I N G S VA L U AT I O N M E T H O D – W O R K E D E X A M P L E O T H E R VA L U AT I O N T E C H N I Q U E S R E L AT I O N S H I P B E T W E E N S I Z E A N D P R I C E CONCLUSION

chapter

6

Chapter 6: Valuation techniques

Introduction Ultimately, the value of a business is that which a willing purchaser is prepared to pay for it.This will depend on a number of factors not all of which can be foreseen before the sale process commences.Different potential purchasers will place different values on a business.Accordingly,while theoretical valuation models can provide a guide as to the price which a business will achieve on a sale, they can also produce valuations which either significantly under-estimate or overestimate the ultimate selling price. An example of this was the sale of the Scottish supermarket chain William Low. A price was agreed with Sainsburys which the directors and their advisors recommended to the shareholders as a fair price, fully valuing the business. However,Tesco decided that it was prepared to pay significantly more to achieve a presence in the Scottish market.The resultant auction realised a price some 60% higher than the one the directors and their advisors had previously felt able to recommend to shareholders as acceptable. While the predictive power of valuation techniques has limitations,it is necessary for a prospective vendor to obtain an indication from his advisors as to the likely proceeds of sale.If the indication he receives is significantly below the minimum valuation which he would find acceptable, there is no point in initiating a sale exercise. A prospective vendor should obtain this indicative valuation from a professional M&A advisor, not from business associates, his solicitor or a friend at his golf club, the following is a description of the techniques most commonly used by acquirers for valuing a business.

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Types of valuation techniques Earnings ratios The price/earnings ratio (‘PER’) method of valuing a company is a technique commonly used by corporate acquirers. This method of valuation involves ascertaining a company’s sustainable profits and applying an appropriate multiple to that profit stream. In determining the company’s sustainable earnings, adjustments will frequently need to be made to its stated earnings to ascertain what the profits of the business would be under new ownership.Examples of such adjustments include deductions for proprietorial or non-business expenses, such as relatives on the payroll, or the payment by the company of expenses of a private nature or one off items such as a profit on the sale of a property. For the purposes of determining the appropriate price/earnings ratio, there are a number of relevant factors.These include: •

the company’s growth prospects;

•

the attractiveness of the industry;

•

the size of the business;

•

the quality of its management team;

•

the strength of its brand names.

The price/earnings ratios on which comparable quoted companies are trading will also be relevant.As the table below shows, on average, private companies sell on price/earnings multiples representing a discount of some 30-40% relative to PE ratios of similar quoted companies.In addition,if there have been acquisitions of comparable private companies in the recent past,the price earnings ratios paid on those acquisitions will provide some guide to the price which might be expected for the vendor’s business.

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Private company price index 25.0 Four month average FT Non-Financials PER 22.8

22.0

20.0 17.7

18.4 17.0

11.4

11.0

14.7

15.0

PER

17.4

12.2 11.3

11.4

12.4

9.2

10.0

9.8

8.5

Private Company Price Index PER

5.0

0 1991

1992

1993

1994

1995

1996

1997

1998

Sources: FT Non Financials (previously known as the FT500) Index PER – Financial Times Private Company PER – Stoy Hayward/Acquisitions Monthly

Case study The following represents a worked example of a price earnings valuation of a private company.

Manufacturer of stoves The hypothetical company being sold is a manufacturer of stoves which it supplies to electrical retailers.It is a relatively small player in the market,turning over some £20 million and making profits before interest and tax of around £1 million. In order to value the company on a price earnings basis, it is first necessary to determine its sustainable earnings.This involves adjusting stated earnings for any one off items or costs which would not be incurred by a purchaser of the business.For example,the owner/managers pay themselves salaries which exceed the amount which would represent normal arms length salaries for the positions in question.The excess over the relevant market rates should therefore be added back to profit.

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Also, in the last financial year, the company has refurbished its offices, the entire cost of which has been written off through the P&L account.As this is a one off cost which does not impact on underlying earnings, it should be added back to profit. Finally, provisions against stock of £30,000 were made as at the end of the last financial year which are deemed to be excessive.Again, these should be added back to profit.This gives an adjusted figure for earnings before interest and tax of £1,180,000. Over and above these adjustments,depending upon the identity of the purchaser, significant cost savings may be achievable by the purchaser realising synergies by merging the purchaser’s business with that of the vendor. Examples include a reduction in overheads through head office cost savings and cost savings achieved through enhanced buying power. Although it will not be possible for the vendor to obtain all of the benefits of the cost savings accruing to a purchaser, a vendor should attempt to obtain part of the value of these savings. In any event, it is essential for the vendor to estimate these additional cost savings in order to work out what is the maximum purchase price which the purchaser might be prepared to pay. Having determined the underlying earnings of the business the next step is to ascertain the appropriate multiple to apply to the earnings stream. The company has a number of positive attributes including the strength of its management team and its brand name. However, it also has several weaknesses, including the fact that 40% of its turnover is accounted for by one key customer, the loss of which would have disastrous implications for the business.In addition, the relatively small size of the business will mean that it is unlikely to attract much interest from either overseas buyers or financial purchasers. Looking at comparable quoted company multiples, companies in the household goods sector are trading at an average ratio of price to earnings before interest and tax of 10 and there is a quoted manufacturer of stoves which is also trading on a ratio of 10 times its latest earnings before interest and tax. Applying a discount of 30% to this multiple to take account of company’s unquoted status and smaller size gives a ratio of price to earnings before interest and tax (PEBIT) of 7. We are also aware of the fact that a competitor of the company was acquired at a PEBIT ratio of 8 a couple of months ago. On the basis of the above information, it is decided that a PEBIT ratio of 7 to 8 would be appropriate for the company. Applying these figures to underlying earnings of approximately £1.2 million gives a gross valuation range for the

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company of £8.3 million to £9.4 million. From these figures we must deduct the amount of outstanding debt of £1 million leaving a net valuation range of £7.3 million to £8.4 million.

Illustration Manufacturer of stoves STEP 1: Determine sustainable earnings Operating Profit before Interest...........................................................1,000,000 Adjustments Profit on Sale of Property .......................................................................(50,000) Excess Directors Remuneration ..............................................................170,000 Refurbishment of Offices ..........................................................................30,000 Excessive Stock Provisions........................................................................30,000 Adjusted Earnings Before Interest and Tax (EBIT)................................1,180,000

STEP 2: Determine price earnings multiple Positive factors

Negative factors

Strong Management Team

Largest Customer – 40% of Sales

Patented Designs

Retail Environment Very Competitive

Good Brand Name

Relatively Small – Little O/S Interest

Solid Profit Track Record

Growth Prospects Solid, Not Exciting

Good Asset Base

Cyclical Industry

Listed company comparison

Comparable acquisition

Household Goods Sector Av. PBIT Ratio – 10

Quality Stoves Limited bought by XYZ plc at a PEBIT ratio of 8 two months ago.

Listed Manufacturer of Stoves – PBIT Ratio – 10 (10 – 30% discount = 7)

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STEP 3: Valuation Sustainable earnings Pre-Interest & Tax: £1,180,000 PEBIT RANGE 7 – 8 7 x 1,180,000 = £8,260,000 8 x 1,180,000 = £9,440,000 Indicates a Gross Value Between £8.3m and £9.4m Deduct Outstanding Debt of £1m Net Valuation Range £7.3m to £8.4m

Discounted cash flow technique The discounted cash flow technique involves an acquirer determining the future cash flows which the business is anticipated to generate and then discounting those cash flows to determine their present day value. Venture capital houses use the DCF technique by determining whether the expected cash flows will generate the required rate of return on their investment – referred to as an internal rate of return. Every venture capital house has a minimum required rate of return on any investment which it makes,usually around 25% to 30%. Before making an investment, a venture capital firm will determine whether,on the basis of the purchase price being asked for the business,it would be likely to achieve that rate of return. When a corporate acquirer uses the DCF valuation method, they will typically discount the expected cash flows by their cost of capital which is the weighted average cost of its debt and equity finance.Thus, for example, if a company had a cost of capital of 15% it would discount the expected cash flows from an acquisition by that figure. If this generated a positive net present value, the proposal would be accepted. If not, it would be rejected. One of the weaknesses of the discounted cash flow technique is that it will often be difficult to determine, with any degree of accuracy, the future cash flows of a business. For that reason it is necessary to estimate the future cash flows conservatively and test the assumptions underlying the forecasts vigorously during the due diligence process. There follows worked examples of the IRR and the NPV methodologies.

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Worked example The purchaser has concluded that he is likely to hold the investment for six years before looking at an exit.Accordingly, it has estimated the likely cash flows over the intended six year life of the investment.This involves calculating the likely net profit stream of the business and adjusting this by excluding non-cash items such as depreciation or amortisation of goodwill. From this figure there needs to be subtracted an estimate of capital expenditure for the year in question together with the estimated corporation tax payment in each year. At the end of the expected life of the investment,the business will have a residual value which will be based on the expected proceeds of a sale or a flotation of the investment.The critical assumption will be the exit multiple which the company will achieve. Most venture capitalists will assume the same exit multiple as the multiple on which they bought the business. In the example shown below, the projected IRR of the investment is 41%.The venture capital house has a required rate of return of 30% and accordingly decides to proceed with the investment. For a corporate acquirer with a weighted average capital of 15%, the acquisition will generate a net present value of £4.6 million so they too would make the acquisition. Y0 £’000 Purchase Price

Y1 £’000

(3,000)

Y2 £’000

Y3 £’000

Y4 £’000

Y5 £’000

Y6 £’000

(200) 800

Sale of Surplus Assets PBT Tax Paid Depn Cap Ex

700

750

900

1150

1500

1800

(100)

(230)

(250)

(300)

(380)

(500)

100

100

100

100

100

100

(200)

–

(100)

(150)

–

– 9,600

Residual Value (3,000)

500

1,220

650

800

1,220

1,400

0

1.15

1.15 2

1.15 3

1.15 4

1.15 5

1.15 6

NPV

(3,000)

434

922

427

457

606

4,755

Cumm. NPV

(3,000) (2,566) (1,644) (1,217)

(760)

(154)

4,601

Total NPV

£4.6 million RR = 41.2%

Net Cash Discount Rate 15%

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Other valuation techniques Return on investment This technique involves calculating the percentage return on investment which the projected after-tax profits of the target company will generate for the acquirer. This is then compared to the acquirer’s required rate of return.

Pay-back period Under this method, the purchaser determines the number of years it will take the investment to pay for itself,that is,to recoup for the acquirer the initial purchase price of the business. For example, a company might have a minimum required pay-back period of four years during which any investment it makes must recoup, in cash, all of the initial outlay.

Net assets method Valuing a business by reference to its net assets is generally not appropriate for the valuation of a profitable business.However,the method might be appropriate in a situation where the company is loss making or where it consists entirely of property investments. Even where a company is being valued on a price earnings or discounted cash flow basis, the net assets of the company will have some relevance. This is particularly so where the acquisition is being partly funded by debt finance in which case a good asset base will allow a commensurately higher proportion of bank finance relative to equity funding.As debt finance is cheaper than equity finance, this will assist the purchaser in paying a higher price for the business. The net assets of the business are also relevant for purchasers who have to write off acquisition goodwill through their profit and loss account and may therefore be reluctant to pay a substantial premium over the net assets of the company.

Industry specific methods In addition to the general valuation techniques listed above, there are a number of industry specific valuation techniques.For example,investment managers are generally valued by reference to a percentage of their funds under management, nursing homes on a price per bed basis, and insurance brokers on a multiple of commission income.

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Such formulae are typically based on prices which have been historically paid for businesses within a particular sector. While appearing to lack intellectual integrity,the rationale for methodologies based on turnover,and other non-profit related variables, is that a bolt-on acquisition of a company in these sectors by a trade competitor will typically not result in a significant increase in overheads. This allows the profit margin a purchaser would achieve on the acquired company’s earnings stream, to be established on a reasonably accurate basis.

Valuing IT and high tech companies Typically, in the early years of their existence, IT and other high tech companies do not have an established profit stream as they are spending heavily on financing growth or building a customer franchise. In the absence of an established profit stream, valuing IT, high tech and young, high growth enterprises is an extremely difficult exercise.Typically, businesses of this nature are valued on a multiple of either historic or future revenues.A case in point is Amazon.com.,which despite the fact that it has never made a profit,has one of the largest market capitalisations of all NASDAQ quoted companies.

Relationship between size and price As demonstrated by the graph below, as a general rule, the larger the business, the higher the price earnings ratio which one would expect it to achieve on a sale.There are several reasons for this. First, as businesses grow, their quality of earnings and risk profile improve as they become less dependent on one or two key managers,customers or suppliers.Also,up to a point,the larger the business, the greater the number of potential purchasers who come into play.For example, few of the major venture capital houses or overseas purchasers are interested in transactions below £5 million.

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P/E Ratios by deal size 14

12

P/E Ratio

10

8

6

4

2

0