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

Archive for June, 2014

Margins and mark-ups

Some confusion is doing the rounds again. Mark-ups and gross margins are mathematically tied to one another, but they are not the same thing. Business owners are generally entrepreneurs, not accountants or mathematicians.

When I ask a business owner what his GP is, it means “what is your gross profit percentage?” The question in its original and colloquial form is deficient in that it leaves out the crucial “percentage” word, but it is never the less a common form of enquiry.

When the business owner responds brashly with “Oh it’s 300%”, he stoops to my level of sloppiness in his understanding because you simply cannot have something which is three times itself. But I understand what he means, which is really: “My mark-up is 300%”.

I know what he means, so we move on. Here is why:

  1. When you pay 100 ZARs for something and sell it for 200, your mark-up is 100%. If you sell the same article for 300 ZARs, your mark-up is 200%. In the initial exchange with our business owner, what he clearly meant was that if his raws cost him 100 to acquire and increase in value and he sells them for 400.
  2. 300% is not his margin; it is his mark-up. His margin is 75%. 25% is his cost of sale (or cost of production). Slowly:
    • He sells for 400 ZARs (100%)
    • To get it ready for market costs 100 ZARs (25% of 400)
    • The gross profit he makes on the sale is 300 ZARs (75% of 400)
    • His selling price will always total 100% (25% plus 75%)
    • If he manages to lower his production cost by say 5 ZARs to 20, but keep his selling price at 400, his cost of production is 20%, and his gross margin is now 80% (20% +80% = 100%) His new mark-up is 400%.

This is why it is important to understand the relationship between the two. Where we talk about large mark-ups of 100% or more, the mistake can be glossed over without any risk to buyer, seller or broker, because it can only ever mean mark-up. But when the mark-up is less than 100%, we have the potential for damage.

Let’s say that a mark-up percentage is 75%. This means that for 100 ZARs of product cost, the business would add 75% of the production cost onto its cost, and sell for 175. The cost of production is therefore 100 divided by 175 as a percentage, which is 57.14%. The margin is now 100% minus 57.14% which is 42.86%.

Getting 75% and 42% mixed up is a potential drama.

Imagine a purchaser asks about gross margin % (gross profit %, GP%, or just plain “GP”). The seller tells him that it is 75% when it is really 42%, causing the purchaser to get excited, put his funds on standby, mobilise his auditors for a due diligence, and consult his attorneys about drafting an offer to purchase.

OK, so generally the damage is a lot less dire, and a good intermediary should sort out the confusion ahead of time. But what about this:

Your mate has just sold his almost identical business to yours, except that he tells you that his margin is 75% when it is really 42%. First you kick yourself for either charging your customers so little, or paying too much for your production, and then with great frustration, you start to make changes to match your friend’s metrics.
Understanding the difference, and understanding that others may perhaps be honestly mistaken is simple, but prudent.

Don’t try this at work

You want to sell your business. You know it is a bit rich on overhead with employees, particularly after you lost that large contract.

You may not retrench part of your workforce to make the business look more financially attractive. We got over that game in 1995 with the Labour Relations Act. Prior to that it was common practice for a seller to retrench all his employees when he sold his business. The new owner, with the guidance of the old owner would then rehire selectively.

There are many business owners and buyers of businesses who believe that the same rule applies today. It does not.

More importantly, if a business buyer retrenches anybody in his first six months in charge, the business seller can be held liable jointly and severally with the buyer for any unpaid benefits arising from whatever action is subsequently take by disaffected employees.

Interest and business value

What would the value of my business be if I had no debt?

The question arose in a recent valuation exercise we did for a small manufacturing concern. The owner was agonising over the fact that he had put up everything he could as collateral for a loan, including the domestic kitchen sink, the “domestic” cleaner herself and other domestic incidentals like his wife and loins linked fruit. The loan was to get his factory working with more up to date equipment.

His subsequent frustration was in the fact that not one of his cash flow forecast months had been accurate. When are they ever? That is another story, but in essence I have never seen an accurate forecast after the fact. That makes the concept of discounted cash flow valuation models tenuous at best.

He envisaged installing the new box of tricks, which would seriously raise production efficiencies, and cause his sales numbers to soar. Not quite the way things worked out: 1) The commissioning of the machinery took longer than expected. 2) The workflow transition had more problems than he could have expected. 3) Customers who were used to a quick turnaround looked elsewhere when they had delays, and found better prices. Years of comfort ordering went out the window.

So when he eventually got going again, albeit it with better and more efficient equipment, he had some work to do to get sales up to speed. “Been there, done that. It is like when…”, I hear half my readers muttering.

So where does he sit now? He has a better mouse trap, and things are looking up. Sales growth is not quite what he expected, but as long as his wife does not find out that she has been pledged to the money lender… Wait… I jest.

His business has a very big interest account every month. The quantum amount is exactly what he was expecting, but the proportion of interest to the turnover is way higher than he had planned for, and frankly he is nervous.

The impact on business value

There is a calculation we do around the mix of equity (value of the shares) versus the amount of debt a business should take on in order to maximise value of the enterprise. It is one of those cross roads questions.

Our hero missed the cross road, and drove straight over the chevron. He’s a tough German off roader, so he’ll thunder through the veld until he gets back onto the right road, with a bit of GPS guidance.

The value of the business has not been affected by the higher interest bill because small and medium size business valuations and sales take that into account. The effect is hardly worth a mention, even though his profits have gone down by the amount of interest. As I say, it is hardly worth a mention; but that is provided the business survives.

His value HAS been affected by the loss of sales, which has had a further direct impacted on his bottom line. So the amount of bottom line decline as a result of sales loss does affect his value (in the short term, provided he survives), even if the loss to extra interest payments does not.

In the near future, as his sales first regularise, his higher capacity will in turn allow for the sales to grow, and because he now has a bigger chunk of gross profit to play with, his bottom line will increase significantly. His fixed overhead is unlikely to grow at the same rate as the sales growth because of the efficiencies his new equipment brings to the party.

He will easily be able to win his lost customers back with competitive pricing and his radiant personality. All things being taken into account somewhat after the fact, his business will be worth much more.

What will happen if (more likely “when”) interest rates rise? That becomes a little more complicated.

BEE and value

More and more, as we conduct valuations of businesses, we see this line item in the expenses: “Donations”. It has taken on a new meaning in our heavily BBBEE influenced way of doing business; it has become a way of easily buying some points towards becoming socially, politically and economically acceptable.

If a business services or sells to a large corporation, or one which in turn supplies a large corporation, this becomes more and more important. You’ll know if you fit into that group by whether or not someone up the food chain has called to ask about your BBBEE scorecard.

We have effectively changed an entrance fee to heaven, to something which is a charity event with a reward on this planet, now. The reward comes by way of being allowed to do business with “the club”.

So how do we treat this line item in a valuation of a business? In years gone by, a buyer would look at it as a possible addition to his own profitability, and calculate value accordingly. After all, it was almost certain that he was not going to sponsor the same mini league soccer side, or the same church as the seller. It was never anything to do with the furtherance of the business.

Now however, that line item has become more of a cost of doing business, dependant of course on whom one wishes to do business with. It is not a charity item which should be automatically taken as an extra profit item by a buyer. Your eventual buyer is looking for the best deal for himself, and he will test all these items very carefully. He will also want to keep your scorecard in place, and so will not tinker with the way you have made it work for you.

Cynically, the benefits the recipients of BEE hand outs are receiving, are the proceeds of a cruel investment their ancestors contributed to by being subjected to 300 years of brutal treatment. BEE in its various forms has had grotesque benefits for a few, and somewhat more humble benefits for some more. In many respects it has had very little, if any, benefit to the majority, and as suggested by the Institute of Race Relations, may have even damaged the prospects of a better life for us all.

  • One thing which is certain; if it works for you to get more business in, then it is a cost of doing business and adds to the value of your business.
  • Another thing which is probable; if you make donations because you are good guy, and not because you have to, then you will benefit when it comes time to sell your business because a buyer will be prepared to add that back to your bottom line, and therefore to the selling price in some way.

Make it work for you. Make sure you know why.

You will have to prove your numbers, and you cannot expect that a buyer will do you any favours in this respect. Getting things in order now, and getting into the habit of keeping them in order will add a few years’ resources to your retirement fund, at a relatively small investment. Understanding why you contribute those “donations” is part of the process.

Single member labour contractor tears

A successful business may be so because it has many customers or in spite of having only one. Of course the business with only one Customer is probably not a business at all. It is more likely to be some sort of self employment scheme which has gotten lucky.

Some years ago I drove into the Johannesburg CBD, down the Rissik Street off ramp where I was greeted by a group of protesters. It’s quite funny to think of it now. They were all white, mostly middle aged and male. They were protesting outside SARS (or whatever it was called in those days), the change to some tax laws. Their placards called on motorists to hoot if they agreed.

The law change was to do with employers no longer being able to contract single workers through the worker’s close corporation. Up until then the company would treat the CC as a supplier, pay the VAT if applicable and then claim the expense as usual. There was no real benefit to the employer, except that he was able to attract and keep some very good talent as a result, and there was less by way of admin involved.

The first time I came across the idea was when I was working in the small remuneration department of a bank in the mid 80’s. It was a revolutionary idea at the time, and we spent much time wrestling with the concept of cost to company, as the bank tried to negotiate with this specialist who eventually headed up a significant division. He always billed the bank as a close corporation.

Ten years later the practice was widespread. For the sole members of these close corporations things were very peachy. With tighter labour legislation the “employer” felt better. For SARS, not so much.

Travel, telephone and even a portion of the upkeep of the family home suddenly became claimable through the CC. SARS was out of pocket. So SARS made it clear that sole membership close corporations would be treated as being in employment relationships with their sole customer. Therein lay the trick: Make sure that you have more than one customer.

A sole customer company is imminently unsellable, even if it has hundreds of employees. Even companies with only a few customers are generally of little value to anybody who is not the technician within the company. The loss of one customer would mean the immediate loss of all the future profits, and probably a whole lot of capital to boot.

With time the dust settled, and single membership CCs quietly went about their businesses. Then in 2010 business rescue and chapter 6 of the Companies Act 71 of 2008 came into being. The very first business rescue that we were exposed to had an interesting twist:

There were lots of employees, and two “independent contractors” who were contracted through their companies. They also did a bit of work for some other customers in the industry, or so was their right.

Part of the rescue plan involved retrenching a significant portion of the workforce. The retrenchment bill was eventually settled with the proceeds of a sale of assets of the company, and all employees were paid out in full. This is where the independent contractors found themselves out in the cold; they were not employees. Employees are preferent creditors in a liquidation or business rescue. Independent contractors are concurrent creditors, and must settle for the dregs alongside the other suppliers.

At some stage in the not too distant future, a similar disaster is going to arise around “employees” being taken out in a major liquidation or business rescue where the troubled company has used labour brokers to run their workforce. The result will be that where they would have been treated in a preferential manner, they will instead be left claiming their usual salary from the labour broker. If the broker is a small outfit with tight margins and small reserves, the labour broker itself could find itself in business rescue with even more business rescue practitioner expenses diluting the pot.

Such are the twists and turns of changing business rules in a country with a history.

Ebb and flow

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There is a simple calculation we do when conducting valuations on businesses; similar to one which is applied by many valuers around the world for large corporations. It is simply a comparison between the operational cash flow and the net profit of the business. Only ours is different!

The thinking goes something like this: It is all very well that a business is selling stuff, and invoicing it; but what if those invoices are being paid very late? We all understand that situation: You did some work at the beginning of the month, invoiced it, and mailed the invoice. You happily went about your junk for the rest of the month expecting to be paid at the end of that month. “Oh no, we’ll pay you at the end of this month. We thought it was 30 days from statement”. So there you find yourself with a nice profit, but no cash flow.

With time, and a fair margin, you are able to drag your business into a cash reserve position where you can carry yourself. On very tight margins, it is still very difficult if your customers pay you late. A strong growth spurt, although profitable, can kill an underfinanced business. Result: No value.

With good margins, strong growth can be exciting, provided these new or bigger customers pay when expected. Paying on time comes from good debtor management. The business has value.

Where a business has strong margins, but poor debtor management, things could go either way, and that is where the comparison between net profit and operating cash flow is most telling.

The metric works well for large corporations, particularly those listed on the JSE, and subject to the rules of the stock exchange. There is a size above which this becomes imperative for private businesses too. But when advising small businesses on their value, something far more important comes into play.

Let me start here: When one, or only a few blokes are involved in a business at a time that the project requires cash, they do what is required:

  • Bond a home
  • Borrow from family and friends
  • Sell a car
  • Delay payments of personal bills
  • Give up the gym membership
  • Take kids out of private schools
  • Eat pap and gravy for a few weeks
  • Give up DSTV {OK, now you’re getting silly – Ed}

Those are the costs of risk that the small guys absorb in order to keep their dreams alive, pay staff members their salaries and generally keep the machinery running. They don’t always have the benefit of calling on wealthy shareholders for more funds, and few small business owners have the luxury of great reserves to draw on.

Until the boat comes in, that is. It’s at this point that things begin to happen – like employees demanding a share of the business. Employee share schemes are not a great idea, and those demands normally happen once the start-up risk is a thing of the past. (That’s what makes them employees).

Along with that comes an ability for certain personal expenses to somehow find themselves in the list of business expenses, and the business owner is able to pay himself a salary commensurate, not necessarily with experience and ability, but more likely with the amount of pain the he endured in getting to this profitable point.

So The result for a public company is that it prefers to keep this bottom line as high as possible to allow its directors to keep their jobs, because as you know earnings drive the share price and the benefits flowing from their stock options.

The result for the small business owner is that he has to balance tax planning with reserves and his own income (and tax attracted). Then when he one day sells his business, he has to find a way to demonstrate real value to the prospective buyer.

So the small or private business owner has another metric in mind, and it usually has very little to do with what is on the bottom line of his income statement. It is the benefit he is drawing from his business.

The public company will compare operating cash flow with net income. The private business owner will compare operating cash flow and his own benefit from the operation, with the net profit. And that is where an eventual buyer of a private business will also have his eyes.  That is where the value is in the business. And that is why small businesses cannot be valued on the same basis as those much bigger entities which adorn the text books of our accountants.