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Business Exit Planning - Company Valuations

Company Valuations

This week we are continuing our series of blog posts on business exits and the various aspects of this topic that we have come across and have been involved with over the years. This week we are going to look at Company Valuations and how you would go about putting a value on your business prior to exit.

You will see in the example below that I have made reference to Spurs in the name I have used– apologies to all you non spurs fans for this but as someone who has followed Spurs for 33 years there have not been many occasions to celebrate! Hopefully we can turn around the deficit from Tuesday night in the away leg and progress to the Champions League final! We will continue to believe!

Background

A key aspect of any exit, whether that is an outright third party sale, passing to the next generation or a management buyout, is determining the value to be attributed to your business or company. As with any transaction the true value will only be determined through negotiation between a willing buyer and a willing seller (think of when you were buying that used car…..did they knock a few bob off, throw in some mats to sweeten the deal?)

Despite the obvious negotiation that will be required, there are recognised approaches as to how a value may be determined and what would generally become the starting point for those negotiations. Even in the event that no money is due to change hands as part of a transaction (e.g. passing your company to the next generation) a value would still need to be determined as on such occasions revenue would determine that the transaction happens at ‘market value’.

What are you actually valuing?

A question that people would often ask is what exactly you are valuing (or selling) when you carry out a valuation on a business. It is fundamental that what is being valued is the right to receive future income, that future income being profits. The valuation is what a purchaser would likely pay to receive that income.

For your typical small or medium sized family owned business in Ireland there is not a huge database of public information available in relation to similar companies that may have been sold. It is therefore not like putting a value on a house where you may have a house four doors up the road that sold 6 months ago for a particular price which you can use as a market guide.

However, there is a broad set of guidelines to arrive at a valuation and the most accepted method to value a private trading company would be on what is referred to as an Earnings Basis. Other methods you may hear or have heard would be Net Assets Basis, Dividend basis or Hybrid Basis. For the purposes of this blog we are just going to look at the Earnings Basis.

What is the Earnings Basis?

In essence this is the future earnings potential of the company. The Earnings Basis takes future maintainable profits (FMP) and applies a price multiple to arrive at the Valuation of the business.

There are two key inputs into arriving at this number. The first is the ‘future maintainable profits’ of the business and the second is the appropriate ‘multiplier’.

Future Maintainable Profits

The Future Maintainable Profits would generally be determined in the first instance, by assessing the historical profits realised by the Company. This review of historical information can give insight into the expected future financial performance of the Company. Past earnings are only a guide to determining future maintainable profits and would always be viewed in combination with projections and known potential changes to the business.

Let’s say we had the following scenario – John and Mary (both 55) having been running a successful distribution business for 25 years, Spurs Distribution Limited. They have two grown up kids but neither has any interest in the business and both are in employment elsewhere. John and Mary are wishing to slow down a bit and start to enjoy some travel and so they have decided they would like to sell their business. Before they make a final decision they wish to have the company valued to get an indication of what it might be worth. This is key to them, as they need to know if they can actually afford to exit the business at this stage with hopefully many healthy years ahead of them in retirement. The business has made profits after their own salaries and pension contributions, on average, of €200k for the last 3 years. The company has no bank debt. Business has been good and the expectation would be that this level of profits would continue. If both John and Mary step out the business it would mean that their combined salaries and pension contributions of €180k would no longer be a cost but in their view, there would be a requirement for a new general manager on a total package cost of something in the region of €100k.

In this very simple scenario the Future Maintainable Profits (FMP) could be calculated as follows:


€'000
Average Expected Profits200
Add Cost Savings180

380
Less New Manager Cost(100)
Future Maintainable Profits (FMP)280


In determining FMP you would also exclude unusual and non-recurring expenses that may have been occurred in recent years from the average calculations.  For example if there had been a significant redundancy or termination payment made which is not expected to recur that would be excluded.

The Multiplier

The next step is to take the FMP and apply a multiplier to it. The more certainty and hard evidence there is to support the likelihood of achieving the future maintainable profits the higher the multiplier that can be justified.  (e.g. things like signed customer contracts, no competition in industry, well managed team, good processes and systems, clean revenue history, good books and records etc.)

You would obviously consider all factors and potential influences on the company continuing in line with past performance such as key customer contracts and relationships, key staff and team, competition, impact of technology, how modern and aware the business is to the need to change and stay ahead of competition and general economic outlook etc.

For a small family owned business such as John and Mary’s the multiplier could be anything between 2 and 6. The less well organised, poorer the systems and team, the higher the level of competition, or less barriers for competition to enter the industry, then the closer the multiple will be to 2. For well managed businesses, with great systems and an A+ management team the higher the multiple that can be applied and justified.

Let’s just say that when the valuer looks at all the facts of this case and takes into account other deals that they have seen in recent months they determine that the appropriate multiplier for Spurs Distribution Limited is 4.

This would put a valuation on the company of €1,120,000. (€280,000 x 4)

The challenge is then to go and realise this value!!!!

Other Considerations

The valuation method outlined above effectively values the Goodwill of the business. In the case of Spurs Distribution Limited they also have €500k in a company deposit bank account which has been generated from historically profits and the company also owns two commercial units as investments which it rents out. These units have a market value of €300k at present.

Both of these would be regarded as excess or surplus assets and do not form part of the valuation. The ability of the company to generate the Future Maintainable Earnings (FMP) is not impacted by these assets remaining in the company and being part of a sale and so they would be separate to any deal. Generally excess cash would be added onto the valuation to arrive at what the final selling price would be. Normal levels of working capital would not however be considered excess as the business will need access to this working capital to be able to generate the profits and perform as expected.

Excess assets such as the ones outlined above can cause significant tax issues for the owners of successful family businesses when it comes to claiming some of the available tax reliefs on exit. We will look at those in a future blog but in our experience it is important to consider the corporate structure you are using as early as possible to ensure these “excess assets” don’t cause a headache at a later stage!

Conclusion

In conclusion, the valuation of a company is not an exact science. As a business owner, by having an eye to the future, you can help maximise the value by preparing and being aware what would impact on those two key inputs into an Earnings Basis valuation (the future profits and the multiplier). A few simple things that any business could start to work on (or at least think about) would be:

  • Can the day to day of the business run smoothly without a need for you to be there all the time?
  • Does the business have an A+ and motivated team
  • Are there clear, efficient and documented systems and process in place
  • Are there documented sales contracts in place where the industry allows for this
  • Good books & records and all financial history available and clean
  • Is there a clean history with revenue or any revenue issues to be sorted
  • Does the business have investment properties or excess cash? Should I consider the structure I am using as a result?

As ever, the above is only a guide and a lot more detail would be needed to conclude on a valuation. If you would like to explore this further or just have a discussion on your future plans feel free to contact us.

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