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

Archive for September, 2015

Quest to be number 1

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What’s the deal with being number 1? New theories of the long tail seem to make it less important than it once was, to be the leader in a product range. If your business is one which offers a range of products, or even a range of services, you will quite conceivably have a top seller, a bunch of very popular products or services, and then a lot of “other”. If your product range is vast, “other” as a group, may well be up there with your top selling items.

There are several web sites hosted by South African companies advertising hordes of businesses for sale – 2,000 and even more. An hour spent on any one of these sites will show that although they have all the businesses they boast, very few are presented as having any value or attraction. There are never more than half a dozen worth looking at, and the rest can be classified as “other”.

Does it make sense that when there are 25 fast food places for sale in Johannesburg in a particular week, that the best one will be sold first, and the dive will probably not be sold at all? If your business is not the best, it will have to wait until the best has been sold and moved off the list, allowing second best to become best, and so on until your business moves into top spot. This is all supposing that there will be no additions to the list. Of course this is not the case. I know that the opposite is true because I see it week after week.

Luckily for many businesses, what looks like the best, may not necessarily be so, but conversely, and sadly, the best is often presented so badly that it is over looked by the market, and left to languish amongst “other” until “better prepared” moves off the leader board, and is not replaced by another “better prepared”.

First impressions do count, but when it comes to selling a business, your dressing up will be put to the test, and it is therefore important to do your homework properly, prepare properly and present for the best sale possible. That’s what this serial seminar is all about: Ensuring that you are the number 1 seller at the time, in your industry or business type.

In Seth Godin’s wonderful little book “The Dip” he writes about the difference between being number 1 and numbers 10 or 100. It is usually typical that:

  • No 1 gets 10 times the benefit of no 10; and
  • No 1 gets 100 times the benefit of no 100.

He then demonstrates with the sales numbers for different ice creams, according to the International Ice Cream Association. Sure enough, Vanilla accounts for about 29% of sales, and Praline (at spot number 10) about 3%. In writing this segment, I looked very quickly at three different lists; one set by a committee, one by natural selection of the public, and the third set by entrepreneurs.

  • Prize money for the Master’s Golf Tournament 2008. Although posted in 2006, I’m assuming that as Trevor Immelman’s name was along side, it has remained unchanged, and was as follows: The winner received $1,260,000 while 10th placed made do with $189,000 (1/6,6 of the winner). Prize money is awarded down to 47th place at $20,300 (1/62 of the winner).
  • Movie sales for the weekend of April 11 2008 show the best grossing movie was Prom Night at $20,8M, while number 10 was Drillbit Taylor at $2M, and number 100 was Charlie Bartlett at $1,5M.
  • The World’s richest list for 2005 shows number 1 predictably being Bill Gates on $46,5B. Number 10 does not follow the law on $18.3B, but take a look at number 100, which comes in at $4,9B.

So the theory works out better for the natural selection than for the committee, under pressure “to be fair”. More interesting perhaps, was the difference between the first placed movie and the second most popular at $12,4M. This demonstrates a difference of nearly 60% in popularity. That’s quite a difference at the top of the ladder.

You can have some fun with this. Google “Zipf’s law”.

So let’s make sure that when your business appears on the market, it is prepared with the best of them, shall we? Stick around, and I’ll show you how.

Losing suppliers

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There is a growing propensity for new cars to be sold without any spare wheel. There is no recent realisation that modern road surfaces provide no reason for tyres to be punctured. Equally, there is no reason to believe that some sort of contingency plan does not need to be in place.

On the contrary, there is only some redundancy in the run flat tyres that are fitted to these cars. One could therefore assume that the possible failure of the initial plan has been mitigated by a combination of good tyre engineering, better roads, mobile phone technology, availability of mobile mechanics, law enforcement and other idealistic plans.

This is all fine and well in the cities of Europe, where it is relatively safe to be a sissy, and where the motor manufacturers would never dream of pulling the wool over the eyes of their customers with any marketing nonsense. Except maybe VW.

For anyone to drive a small car in South Africa, anywhere except in the leafy green suburbs of the safer cities, with no spare wheel, would be crazy. Vehicle owners in the more robust environments all have a plan B, in a more sturdy vehicle, with an adequate spare, and the tools to replace it.

We have to look to a more reliable outcome where the backup plans are dodgy, and the risk of failure has such dire consequences. This is all about supplier redundancy, again.

The risk of supply failure is playing out in the VW supply chain to Swiss car retailers, where the VW diesel test fraud has caused authorities to ban the sale of the vehicles in that country. That means that a bunch of car retailers will suddenly find themselves without one of their favourite sellers on their shelves, almost without notice.

The ramifications are huge for the entire supply chain, all the way down to the suppliers of platinum (South Africa) where that metal is used in the catalytic converters to make the emissions (supposedly) palatable.

The lesson to be learned for business owners is that of supply chain redundancy. If your supplier is suddenly unable to keep product on your shelves, where do you go?

Key in the business valuation process, is testing a business for this sort weakness.

  1. Are there alternative suppliers?
  2. Does the business have a relationship with alternative suppliers?
  3. Is the business somehow embargoed from buying from the alternative suppliers?
  4. Does the business regularly buy from a cross section of alternative suppliers?
  5. Is the business able to shop around for the best price, and actively keep suppliers on their toes, price wise?
  6. Is the business able to regulate its gross margins through negotiations with alternative suppliers?

How does your business rate in those questions?

While you ponder that, consider putting off the purchase of your new mid range family saloon, as African countries look forward to a surge in supply of cheaper diesel powered VWs in the next year or so, as they are dumped out of the European market.

Romans, romance and exhaustive examination

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Legend has it that in Ancient Rome when the supports used for building an archway were removed, the builder was required to stand under the arch as an assurance that the thing would stand. Those that still stand today, had builders who lived long fruitful lives.

When a business is placed on the market, the eventual buyer needs some sort of assurance that he isn’t buying a bag full of lemons. This assurance is generally gained through the due diligence process. The due diligence (DD) can take many forms and be of varying degrees. I am always very wary of an open ended DD. There is just too much risk for the seller. Instead I prefer to work on the promise – prove or lose – format. The DD should be defined around the purchaser expectations, so the seller knows in advance whether or not the deal is on.

It works like this:

  1. Give enough information to all prospective buyers to enable them to make a decision about whether or not this business might be a proposition for them within their own scope of expertise, ability, interest, expectation etc.
  2. Provide them with enough high level financial information for them to arrive at a preliminary opinion of value to them. Discuss that value expectation with the buyer.
  3. In order provide a value proposition, the seller will have to make some bold statements around the way things are done. It is important that these be kept to within reasonable limits, and be 100% verifiable.
  4. Let me say that again… For this process to work, everything must be 100% true and verifiable.
  5. If, subject to the seller proving all the promises he has made, the purchaser’s value paradigm settles the seller’s expectations, we have a deal.
  6. Back briefly to the 100% promise. If the seller has been honest in his promises, there is no reason why the deal should fail, other than through a failure to perform by the buyer.
  7. Before the DD progresses, the seller should satisfy himself that the buyer makes promises about his ability to perform – to pay. If that promise is broken, then the seller should have meaningful and material recourse by way of break fees, deposits and the like.

With that all in place as a departure point, the buyer is then able to constitute his offer to purchase. With the help of a skilled intermediary, this should be put together as agreement of sale, with input from both sides, rather than the somewhat ham handed bully approach of “this offer expires at the close of business on Friday”. The ultimatum tactic has its place sometimes, but should be avoided if possible.

In formulating the agreement of sale, both buyer and seller can be kept happy with the use of suspensive conditions of sale (or conditions precedent). That particular process works like this:

  1. The seller’s promises are put to the test in the agreement of sale.
  2. If any of the promises fail, the buyer gets to walk away without having lost anything except his time.
  3. If the seller goes into the agreement knowing that he is going to be able to prove all his promises, he can also know that he his business is going to stay sold.
  4. The intellectual property remains safe within the realm of the seller until he has a signed agreement of sale, which he knows will be consummated because his promises are all provable.

In a series of articles following this one, I am going to unpack some elements of typical due diligence exercises. Just go to the “due diligence” tag on the right hand side of this blog to get the updates as they are published, or to read past articles.

The growth of small things

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Which element of your business is growing the fastest?

One measure of risk in a business, is the speed with which a business can adapt to a rapid drop in sales, and the possibility of such a drop.

Central to the problem is that operating or fixed expenses are just that – fixed. In good times when the money is flowing, the tendency is to allow anything fixed to rise, because we can. Those new mobile phone contracts are not easily turned off, and nor are employees which become surplus to requirements.

Gross profit is made up of two constituents – the ability to negotiate input costs of purchases, and the number of sales made. An often unrealised input cost is the early payment discount offered to customers.

We look at the income statements of hundreds of clients in our valuation exercises. Very few of them operate on a net margin above 10% of sales (the net profit divided by the sales). Most of them are around 5%. Some are at 2% or even 1%.

On very tight margins, there is a propensity to give in to cash flow pressures and offer early settlement discounts to customers. Those discounts are usually around 2% of the outstanding (sales value, plus VAT). You see what happens here?

Tight margin businesses give away ALL their profits just so they can continue to exist.

Two undeniable things

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We are beset by rules of thumb.

Here are two which few would argue with:

  1. There are some big corporations, and even big private businesses sloshing around with cash right now.
  2. Times are tough.

Do the cash flush pay out dividends? They could, and the shareholders could take their money and invest somewhere else. For some, it means a time of shareholder boasting as that shiny red car is bought, to be admired by friends and colleagues.

More likely in the astute business environment, is that the excess money is used to ramp up capacity in the business for the good times which will certainly follow. This can be done by way of training employees, but even that usually follows planning for the acquisition of bigger, better and braver equipment. When production starts to pick up, so existing and new employees can be trained on the new equipment.

Another option is for the cash flush to start “dating” the cash starved within their own industries or perhaps in complementary supply chain businesses, on their own terms. They look for businesses with growth potential, but which simply do not have the resources to grow any further under current constraints, or which have screwed up their cash flow recently, or who have starved themselves of further lines of credit, or which need restructuring, or which need experienced management.

Ashley Madison and Tinder aside, we have been acting as match makers in recent times between the rich and the prospectfully {made up word} future rich. Some exciting deals are in the pipeline.

These big brother investors are able to offer so many of the talents which are often lacking in growing businesses, and of course chief amongst them is cash for growth. While this may seem like a bit of a liberty to the business owner who has got his business this far, the additional talent can have far reaching consequences for the future prospects of the owner.

Let me explain.

In days gone by, the owner wanted “to sell my business”. This progressed to him wanting “to get out”. The euphemism is now “exit”, and its more laborious “exit plan”.

Investors with an agenda understand the concept of “plan” in the “exit plan” colloquialism. Often we are told by business owners that when the buyer comes along, “he must just come with cash”. The problem with this approach is that it is aiming to remove all future risk from the seller, and transfer it to the buyer, and significantly so. The result is a poor sale.

How is this for an alternative: A part sale, accompanied by significant investment in terms of money, talent, resources, connections and synergies. This is soon followed by significant growth with resources. Under the auspices of a well designed agreement, the owner is able to exit the balance of his shares only a few years later, with the remainder of his shares worth a heck of a lot more (per share) than they were originally. Significantly more!

Who would not want to do it this way? And why not?

You are where you are because you have pushed darn hard to get here. What if you were given a good healthy kick in the bum to get you really rocking and rolling for a few years?

You know… because getting here has not always been conducive to saving for retirement, the next project, or a better life. Here is your chance for growth.

 

The risk in transactions

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Wherever people talk about businesses being sold, the conversation inexorably gravitates to two things; value and risk. We’ll tackle the valuation thing in a future installment and elsewhere on the Suitegum web site, but for now I would like to visit risk.

In that hypothetical conversation above, the risk always seems to be for the appetite of the purchaser. You know; he was sold a lemon, or he was never cut out for that sort of business, or the staff all bailed on him soon after he took over, or half the customers were the seller’s wife’s friends and they have all stopped buying, or the anchor tenant moved away, or… and so it goes on.

But if you are the eventual seller of a business, you are probably not much interested in the problems buyers have, are you? Perhaps that is the problem with suppressed values

One of the first things that any prospective seller of any business asks me is what price do we think we can get for their business. Either that or he tells us exactly what he wants, and what his bottom line is. Either way, I think we can safely infer that it is the money that most sellers are after, and why not?

If sellers want to get paid for the business that they are getting out of, then not getting paid is a significant risk, which can be minimised through good transfer management. That management could include managing the process of agreeing to any term payments in order to get an even higher price. This is a popular way of selling businesses in other parts of the world, where small businesses trade at significantly higher PE ratios than they do in South Africa. There is no reason why we shouldn’t try it here from time to time with the right businesses. Is yours one of them? I can report that one of the reasons that businesses are getting significantly higher prices in the greater than R20M mark is because sellers are agreeing terms on the one hand, but are also prepared to warrant future earnings while they stay in senior management during that pay out period.

Another realistic risk to closely held family businesses is the prospect of the family heirloom and legacy being destroyed. After all, it would be nice to be able to point to that landmark and tell your grandchildren that you started it. The only real solution to this is to refuse to sell to someone who you may judge to be incompetent. But then a cold hearted objective process degenerates into a subjective, indecisive one.

If your business is well prepared though, the prospect of kicking a poor purchaser into touch should not be that scary because, as we’ll see later, you will have more than a few potential buyers chasing your offering. There are not that many sellers around who would have the constitution to refuse the money in these circumstances. But by the time you have worked through this course, that could be your profile.

My biggest concern with presenting this series is this: Are you selling your purchaser a good business? Well hopefully you are honest, and you are reading this to maximise a fair price, rather than rip the ring out of some poor unsuspecting buyer. Of course that is your next risk; being sued by the purchaser, and losing! We can deal with that too. And as with most things that are painful, prevention is better than cure. Truth will keep you free. Keep that in mind.

For now you need to consider that when you do eventually take your business to market that you present the best butcher, baker, tinker, tailor, or whatever that there is for sale at that time. That is the aim.

Customer grade counseling

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In the first three presentations on key value indicators (KVIs) I used the examples of exposures to premises and to customers to show how strengths and weaknesses in each business can contribute to perceptions of, and actual value in a business.

This short video shows how questions are asked and answered to get an indication for each business as to how that particular KVI, in that business, in that industry, and even within the greater environment; should be positioned. In a world subject to scientific measurement at every turn, this methodology manages to streamline some of the “art of valuation” into something more defendable.

The valuation interview interrogates all the KVI areas of a business, and apportions strength or weakness scores to each, which is then applied to a profile for a particular industry, within other global sub categories, such as geographical, societal and economic.

The video is simplified, to give an idea of the process without confusing the overall message.

 

Buy-sell agreements

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The scenario in many businesses which have two or more shareholders, is that if one of the shareholders is to die, the shares he owns are, through the process of liquidating his estate, handed on to someone else – his heir or heirs.

This might not be to the liking of the other shareholders, so to forestall any unforeseen effects, they agree (while everyone is alive and kicking) that in the event of the death of any of them, the others will buy the shares of the deceased. It is usually a non negotiable item; after all, who really wants “that woman” kicking around in AGMs asking awkward questions, and grinding away at that axe?

The event is insured by way of life policies owned by the other shareholders on the lives of one another. The arrangement is all good and well.

But what amount is insured for? Some training documents for the brokers actually call for using “an arbitrary value” as the business value. Then there are some other arrangements involving lose multiples of various outcomes.

If that seems like a recipe for dispute; well that’s because it often is. Why should Mrs Axe Grinder be paid for her late husband’s shares at a 30% discount to real value? In particular, why should she settle for that when her brother in law is a hotshot attorney who knows the Companies Act, even more particularly, has an intimate understanding of sections 163 and 165? You have probably guessed by now that those sections hold some magic; and they do: They provide all sorts of natural South African remedies for minority and other shareholders who feel they have been treated unfairly.

Conversely, what if the business is not worth quite as much as the life insurance person thinks it is, and the shareholders spend some years betting on a book at too high a price? Sure the money will be paid out, and it may be a very good deal for the deceased’s spouse, but perhaps the surviving shareholders think that it was all a bit rich, particularly when they are all young and fit, and he is fat, flourishing, and somewhat less than fit. They will have had to pay over the top on two accounts – the dead partner’s insurance was more expensive than theirs, and the business is not worth nearly what they have been paying for.

Just a thought…

We have many clients who have their business value reviewed on an annual basis, and in a way which allows for the value of the business to be decided fairly in the event of the mid term death or disability of a shareholder. So there is a defensible way of dealing with annual sales cycles, quiet times and peaks.

If you have partners, shareholders or investors for whom this would make a difference, and want to explore some easy way of making it happen for you, please drop me an email on mark@suitegum.co.za.

 

Best in the west

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There is a lot to be said for the west.

OK, so there is at least something to be said for the west. I grew up on the West Rand, and I still play games there. As stupendous as the discovery of Homo Naledi is concerned, the truth has been exposed: Ultimately we all originated from the West Rand of Gauteng. Yes, even Donald Trump and Jacob Zuma! But not Zwelinzima Vavi. Of course we’ll know for sure in about fifty years when the scientists have stopped arguing with one another about different theories.

“The best in the west” has a nice ring to it – a marketing call from the last century. Beyond the metaphor, it is what we are after. Consumers look for it in their monthly grocery shopping. We argue about the best cell phone signal. We haggle about value in the housing market. It is what business buyers are after.

Given the choice between two businesses, any investor will take the one which offers the best value for his investment Buck. In making that consideration he takes a lot of his own intention into consideration, but (more metaphors) “first impressions count”.

The initial presentation is absolutely key to the consideration he continues to give the prospect.

So it is with some trepidation that any investor will continue to look at businesses which struggle to produce a set of financial statements for the last few years, who take weeks to provide the latest management accounts, and which cannot easily provide details of the owners’ drawings, loan accounts, and other elements of value to the decision making process.

While these unnecessary delays are happening, there are other better prepared businesses out there competing for the same investment Buck. It is a hardy and dedicated investigative investor who will stick around with his decision making until the seller’s accountant comes back from leave, and starts putting the numbers together.

There are easy and well practiced methods of getting acts together, painlessly and in good time.

 

Understanding the sale process

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The sale of any business or even part of one, follows a set of logical steps. The deal is always possible even if one or more of the steps are left out. But by leaving steps out, value may fall, as might efficiency of the sale. You will notice, as this series unfolds, that I bang on a number of drums. This is one of them. Always have your business prepared for sale.

Preparation

By having the business prepared for sale, even at a time when that sale is unlikely, means that in the dramatic event of a forced sale beyond one’s control, the best price can be achieved within a reasonable time.

 

During this course we will learn about preparing the documents, maintaining crucial records and preparing a killer pitch deck for the benefit of your purchaser. What can you expect from there?

 

Once you decide it is time to actually move ahead and sell the business, your appointed business transfer intermediary will have a set of guideline processes to follow. This will commence with you answering a set of questions about your business which will give the broker a good idea of how the business operates, but more importantly will help set you up to present the business to the market.

 

In due course I will help you set up your own pitch deck in an easy way, far surpassing the standards set by most brokers. More about that later.

 

Your broker will present the business to a number of prospective buyers, importantly not just one or even a few. If he has done his job properly, you will be shielded from the least likely prospects, and will only have to attend the follow up meetings with well qualified investor buyers.

 

It is generally a good idea as a seller to not attend the initial negotiations, but rather to wait for draft documents to be presented, written and preferably signed as a formal offer by the purchaser. Of course this is a matter of personal preference of each seller, but I maintain that staying in the background gives you the chance to discuss any offers with your intermediary without pressure from a buyer’s death stare, cold steely eyes boring into your “desperate to sell” quaking heart. You will also then be in a better position to formulate a counter offer if necessary, thereby once again maximising your return.

Success

With an agreement of sale having been negotiated and signed by both parties, a due diligence period will follow where all the representations made in the pitch will need to be proven by the seller. It is important that you do not agree to any due diligence terms which you know you will not be able to live up to. Particularly, you should avoid subjective terms such as “ensure that the business lives up to the purchaser’s expectations”.

 When the due diligence is complete, the business is handed to the new owner, against a rather tidy sum of money. On bigger deals the seller is very often required to stay in the business, particularly if there is a thin management structure. We’ll deal with this in more detail later, too.