Musings on business value, sale preparation, sale negotiations, sale structure.

Archive for September, 2013

Don’t kick your auditor into touch just yet.

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Elsewhere I have written about the feeling I have that banks are soon going to insist that all businesses of any size, indebted to the bank in any way, must have a proper annual audit conducted on the business.

For reasons of value and the eventual selling price of a business, it is also a good idea to maintain the highest standards of reporting in the years leading up to a sale. Certainly we apportion greater value to better reporting standards when conducting a valuation.

I am reminded of a business I sold some years ago. In the final negotiations, the due diligence was tested by a cuppla corporate guys who had decided to exit the big business environment, and take over a reasonably small business. We’re talking about R10M here, and about eight years back, so perhaps not a tiny business.

As we were hammering out the finer details, the purchasers let the auditor of the business know that they were going to be sticking with the firm. The message was clear: “You guys have to carry some responsibility in the due diligence”. I believe the same firm is still involved, and the business has grown significantly since then. Imagine the safe guard given to a purchaser where the auditor is retained. If anything untoward does appear after the seller has ridden into sunset, there will be serious consequences for the auditors.

Compare that to a business which has a set of financials laid out on a generic spreadsheet, accompanied by the usual director platitudes, and very limited (if any) notes. It may all be in fulfillment of statutory requirements, but how far would these numbers really be trusted, even if they are going to stand up to scrutiny? The old first impressions story…

 

Pulling the PIS out of auditors

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When the new companies act was signed into law, effective May 2011, there was great relief from many small business owners, as it greatly reduced the requirement for audits, on the one hand, and on the other hand, close corporation owners were able to easily convert to what traditionally have been more respectable business vehicles, without having to incur large annual auditing costs. They could now run their businesses within the limited liability vehicle of a (Pty) Ltd, but not get bogged down by annual audit requirements.

Let’s rewind a bit:

In the “olden days” all companies were required to have an audit conducted annually. Close corporations (CCs) could submit themselves to an audit, but it was not required. so if a businessman wanted to be left to his own devices, he opted for the CC route. The problem was that only natural persons could be members, until a few years ago when trusts could become members through nominees.

So when we sold a business, companies were pretty much assured of an easier route to market, and a higher price, unless all sorts of warranties were agreed to by the seller members. That is all very much understandable – why would anybody toss more money at a dark hole?

Then along comes the “new companies act” (Companies Act No 71 of 2008). This decrees that there shall be no more CCs registered; only companies. To alleviate the compliance issues, it further directs that only companies with a public interest score (PIS) of 350 or more, need submit themselves to an audit. Below PIS350, the other threshold is 100, below which the old close corporation standard holds. From 100 to 349, an audit is not necessarily required, and unlikely, but the person conducting the review has to have certain qualifications. With obvious relief, many small company shareholders and directors gave the archers’ salute to their auditors, and made friends with a friendly accounting officer to review and sign off their much simpler statutory annual reports.

 

Just as an aside; here is how you calculate your public interest score:
    • The average number of employees in the company for the last financial year (or part thereof). So an answer of 7.8 would give a score of 8. Directors are employees.
    • One point for every R1M of third party debt at the end of the financial year.
    • One point for every R1M of sales turnover during the last financial year.
    • One point for every natural person who at the end of the financial year has a direct or indirect beneficial interest in any of the company’s issued securities (shares). So if shares are owned by a trust, then add up all the beneficiaries for the score.
So you see, it is PIS easy to calculate, and it is only significant businesses who are going to get to 100 or more.

 

This creates an issue for buyers of businesses, because they have little to hold onto in reaching a value. Somehow “trust me, I’m a seller” has less value than a positive bank balance.

So we have started suggesting to companies that intend to sell their businesses, or to shareholders that intend to sell their shares that they maintain their audit record and pay the extra cost each year, in order to make for more successful sales in the future. But things are likely to go a bit further than this, I think:

A lot has been made of business rescue – chapter 6 of the new companies act. It is in these processes that certain abuses are unearthed, which would not have been missed in an audit. I think that creditors in general are likely to get a lot more sticky about certain misdemeanours in the not too distant future, having burned their fingers through not fully understanding the business rescue process.

In particular I wonder

  • how far away we are from banks only extending over draft facilities to companies who are audited annually
  • how many car loans are going to be extend to companies which have not been audited
  • how many company credit cards will be handed out, similarly
  • for how long suppliers are going to allow credit facilities to be extended to companies which have not been audited.

Under the old act there were criminal sanctions in place for directors who flouted the rules. With the advent of the new act, those criminal liabilities which could never be policed and prosecuted effectively, have been replaced with allowing the corporate veil to be pierced by the creditors of a company. So no matter how deep the level of trusts, the housing of assets and the flimsiness of your trading company, an upset creditor with means, can make life very unpleasant for you if you have been silly.

I think though, that they are going to be taking a different view – lend or extend credit only to those companies which are audited – just to add another layer of accountability when the business is put into business rescue.


Don’t do this

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Don’t believe that you  can retire from a small or medium business and live off the dividends which will flow, because they always have.

Here is the theory: The business is well run, it is managed by people who do everything for you. Yes, you are in the business on a sort of daily basis, but you don’t do much more than show your face. So why be there at all? You go away for a week here, and a week there. Never a problem…

So why not leave it like that, and go for one week long leave after the next, and then the next. What you’re suggesting here is that you retire, and leave the business to run in your stead, managed by the same people who are currently there, and doing a good job.

Here is the practice: You announce your retirement, and throw a small party. For a while, you have let “them” know what your plans are, and you have announced the anointing of your successor, “who really has been running the company for the last year, you know”, you will tell everybody.

Here is the outcome: The person managing your business is not an entrepreneur like you. She is a manager, and probably a very good one. But if she has no skin in the game, she will not pay as much attention as you do (even if you think you don’t). Like it or not, you really do a lot more than just go on leave. People really do need you to be there as a safety blanket, someone they can call for a bit of assurance, to confirm a decision, to give a gentle pat on the back. You know what I mean. You really do, if think about it for a short while.

So the outcome is that morale will fall, almost certainly from the first week. The brother leader has gone, for heaven’s sake! The new boss has not grown up in this environment of dealing with all the different aspects you have become accustomed to over the years; most notably the workplace politics.

 

The elephant’s box

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So how do you eat an elephant? One bite at a time… Yawn…

I recently moved house. I have about 1,500 books. Some very old (300 years) some very new (on Kindle). Packing books in boxes is a tedious, but fairly simply affair, once you get to grips with the fact that only the old Penguin books were ever of a uniform size. Today books come in as many dimensions as there are dimensions, so filling a box to its optimum is a game of tetris, with muscles.

Why muscles? Well because unlike the elephant meal, moving 1,500 books is done in the opposite order. You can put them all into a box, one book at a time, but you cannot easily carry a box which is too big, and full of books. The weight is one thing for middle aged aching business consultants; the bottom falling out of the box is another. So, like the elephant, the job is best done in smaller boxes, but lots of them.

And that metaphor leads us on to the difficulty of preparing a business for sale in one large chunk…..

It cannot be done with any sort of reliability, or without getting a severe case of indigestion. That is why we have created the Suitegum Splinter program.

Imagine the monthly prompt for new information, slowly but surely building a portfolio for the future buyer of your business to be sold with.

Imagine not having to do this in an emergency, after a truck has plowed through the vehicles carrying your managing director?

http://www.youtube.com/watch?v=GKmm-T4woeI

Or just imagine knowing what your business is worth on an annual basis, reliably. That will enable you to plan for your retirement, think about your next great venture or just feel smug about what you have managed to achieve so far.

The Splinter way allows you to continue to operate your own business while someone who has been there before gets on with the job of polishing a product for delivery whenever you choose to do so, or is chosen for you by some unfortunate and unforeseen event.

Just a quick question: Who has never raced away through an intersection when the lights change to green, without first looking left and right? I will never do that again.

 

 

 

Why whine about wine

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I think it was Johan Rupert who famously said that the party making the best return on investment in the wine industry is the waiter. Zero investment, zero purchase, but in theory he receives 10% of the final retail sale value of each bottle he flogs. Does that make waitering a valuable business? Of course not. I suppose some spots might be traded. But they would be jobs changing hands, not businesses.

On the other hand, petrol garages working on gross margins of only 8% are very valuable businesses, despite the fact that a robbery at one of them takes away several weeks’ profits in one fell swoop.

I still have people arguing the huge value of their businesses based on the turnover of the operation, rather than the profit, the assets or the cash flow. To boot, they will base their own valuation theories only on the last three, two or even only one month. The remarkable thing is that at the lower end of the market, people even buy businesses on these principles.

Of course serious buyers with access to serious capital take a much more serious view of what they’re getting themselves into. If you’re that sort of person as well, then you should take the value of your business more seriously as well. You will understand that a business value is based in part on profits (the bottom line), but is influenced by many other things:

  • The momentum of the sales and profit
  • The exposure to small groups of customers
  • The redundancy of suppliers, or otherwise
  • The exposure to staff
  • The threat or opportunities from emerging technologies
  • Shrinking or rising margins
  • Levels of inventory
  • Don’t discount the value of turnover!
  • The intellectual property locked up in the business
  • The “pipeline”
  • The reserves of the business
  • The state of the assets
  • And many, many more besides.

I mention the reserves of the business, as something related to this is being played out in the gold mining industry at present. There is an interesting tussle between the new union AMCU and the guys we have grown to love; NUM. In that powerplay, NUM is demanding a 60% increase, while the employer mines are offering 6%. With all that daylight between the sides, it is not likely to be pretty. In the meantime, AMCU has not yet made its demand.

So why the sudden political bent to my blog? So unlike me!

Well Neil Froneman, the big cheese from one of the employers (Sibanye) told Bloomberg that “we can ride out the storm for a very long time”. That was around the same time as a Sunday Independent report about the four biggest gold miners hoarding cash and making arrangements to borrow more if necessary. Of course they will be saving a bunch of money on unpaid wages for the time as well.

So the point about reserves: If you have them, you can survive more easily in times of trouble. You can even survive several years of losses. I have clients who have done so. Three years of losses. And yet conventional wisdom tells us that their businesses are worthless. Meanwhile around the corner, the business with a R3M profit last year, but a very generous dividend policy is judged to be more valuable. When conducting valuations, one needs to consider the bigger picture, and place less trust on the individual who applies a simple formula to any particular metric, in a few minutes.

Conducting a proper valuation is a serious and momentous exercise upon which people’s lives can be changed.

My thanks to Nic Borain for the idea for this blog.