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Valuation indicators Shareholder agreement

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If there are more than just you as a shareholder in your business, chances are that you have not put in place one of the most fundamental building blocks for the creation of value in your business:

The shareholders’ agreement

Let me explain. (Oh, and even if you are the sole shareholder in your business, you should pay heed.)

The shareholder’s agreement is more than a document governing the number of shares or percentage of shares held by each person (or entity). It helps deal with the other shareholders’ family in a time of crisis. It provides you all with a negotiated plan of action in the event you are incapacitated on a Sunday evening. It is something which can possibly stop your bank accounts being put under stress by the wife, girlfriend or children of your now dead partner.

The shareholders agreement will dictate how shares, or even the whole business will be sold or otherwise dealt with in the case of a fallout of shareholders. When you guys got together you never considered that one day there would be a divorce. The state forces us to contract for this eventuality in our personal lives, or face the whim of the courts. But in our business lives, which usually get started some time after our marriages, we are reluctant to take the same steps.

The shareholder’s agreement will help to protect minority shareholders in the case of a sale of the business. If you own less than a portion of the total equity, you are at risk of arriving at work tomorrow morning to find that in place of your shares, you have a cheque for the proceeds of the sale, which you knew nothing about.

A shareholder’s agreement can insure that all shareholders have a preemptive right of first refusal on the sale of any of the other shareholders’ shares. That can be very valuable in five years time when Big Larry wants to take off with his mistress.

A shareholder’s agreement can regulate the manner in which new shares are issued, and give you some say in the manner in which new issues are taken up, and by whom.

What happens if one of the other shareholders is a company, and that shareholder’s shareholding changes? Concentrate here. The control of your biggest shareholder changes to that of your competitor, or your ex wife’s new boyfriend… You don’t want to find that your electronic key no longer works on the first of next month.

What have you agreed to in the event one of your shareholders is sequestrated or liquidated?

How, or on what basis will you value the shares of the company in the event one of the shareholders wants to sell his shares to the other shareholders?

How will the shareholders’ loan accounts be handled in any of the above circumstances? And how will funding be sourced and repaid?

What is your agreed dividend policy; or do you simply have an argument at the end of each year? Wouldn’t you prefer to have left some of that money in the account after the last financial year end?

Many businesses actually fail because this very important document is not in place to regulate the way shareholders direct the directors, who (let’s face it) in our realm, are usually the same people. Such a failure leads to all the shareholders losing all the value built up in the business from the start to the time of the failure.

But most important, one day when you decide to sell the business, and all has gone well, how will you agree on the method of sale, and the distribution of the proceeds?

If you are a one man shareholder, read the above again, and give it a think. What will you do when someone offers to buy a portion of your business one day. I know what you should do. Visit an attorney with all these questions, and a bunch of others I have not brought up.

But there is more…

The memorandum of incorporation (MOI). The government put this into place for us a few years ago. Of course we were given an opportunity to make it agree with what we intended in the shareholder agreement, but most of us didn’t bother. The problem is that if there is conflict between the MOI and the shareholder agreement, then the MOI will hold.

Really. It may really be time to spend some money with an attorney.

Very willing sellers

Selling too high doesn’t happen often. But hey, if you can get it to happen without lying, cheating, defrauding and incurring financial or liberty liabilities, then why not?

Let’s be clear “selling too high” is not a seller problem. For the most part it is not a buyer problem either. Willing buyer – willing seller, and all that. Nobody buys a business the way one buys a house; you know, half an hour snoop, some estate agent pressure, a clumsy deed of sale, and the deal is done, save for the bond arrangements.

Selling businesses is an entirely different matter. Weeks and even months of investigating the business history and the likely future are condensed into a variety of different business plans and financial forecasts. Through that process, if any undue pressure is suggested by the seller, that bluff is called quite quickly, and usually with devastating consequences.

The best way of speeding the process up is to give the investor what he wants, and in an easily usable format. The investigation and due diligence process is a gruelling one. These guys are often tasked with other people’s money, which demands a return. If it goes wrong, then their round bits are on cubed things.

In a forest of poorly prepared businesses with high asking prices, a well prepared business and owner has a better chance at hitting the jackpot.

I was involved in the sale of a business about ten years ago where a plan came together quite beautifully. It all happened like this:

About a year before the sellers placing their business on the market, they had spoken to me. I’m a “call a spade a spade” kinda guy. They hadn’t liked the message I gave them. So they went off somewhere else for more comfortable sale story. It did not take long to get an offer. Sort of in mid reality check, a mutual friend suggested that they run it by us for another opinion before accepting.

That took some doing, but we all put our big girl panties on, and had a look. Frankly, the deal in offer was such a waste for the sellers. They were selling too low, on lousy terms. I told them as much. Well not exactly.

What happened after that, taught us all some valuable lessons in being prepaired for sale – the gentle art of identifying a bunch of potential future owners of a business, and pre pairing for future benefit to all.

Valuation indicators Type of business (part2)

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In PBFS015 we ruffled a few feathers in the retail industry. I suggested that the value of retail businesses is very volatile. You will remember I said that retailers are at risk and are exposed to the effects of interest rate changes, government policies and global crises.

So what about other sectors – the rest?

Obviously these businesses are also at risk of the external factors pressing down on their full over draft bladders. But I would venture to say that on the whole, the effect on them is much less dire, with some exceptions.

Some consultants and “luxury” suppliers are perhaps almost as volatile as retailers. The so called corporate gifts businesses lose their finger nails on a slippery slope of cut backs by their customers in hard times. Their biggest exposure is often the fact that they are single parent stores with only a few customers. If one large customer pulls back on ordering, the entire net profit of the business may suffer.

The saving grace of the corporate gifts business is that most of them operate from home, and unlike their retail cousins do not have huge rental bills waiting for them at month end. They are more likely to remain in business during tough times; and like retailers, their multipliers fall precipitously.

Wholesalers to the retail industry are perhaps even more volatile. At the first whiff of trouble, their customers, having ridden the crest of a very profitable wave are quick to “destock”, driving their store room volumes down. Not only will a wholesaler’s customers purchase less, but they will actively actually not buy at all and cancel orders, leaving the wholesaler with an over stocked business, and all the risks that entails. In tough times they tend to shed customers while surviving customers purchase less. It seems though that their biggest customers survive the tough times, and a boom happens as the retail sector wakes up in the upturn. There is a big shift in multipliers in the wholesale sector, from boom to bust times, although not as remarkable as in the retail sector.

Factories are much less reliant on the position of their premises than are retailers, and are able to move routinely, with the exception of a few for whom their buildings are purpose designed. Most factories though, have to relocate as they grow, in order to survive anyway. Moving premises is used as a marketing opportunity, rather than being regarded as a marketing catastrophe. Tough times for factories usually result in lower utilization of capacities, less money spent on overtime payments, lower raw materials costs and a sharpening of the pencils of salary negotiators. The biggest impediment to factory values in tough times is the access to credit for prospective purchasers, and there are therefore fewer of them. This naturally drives prices down, but not nearly as badly as for the retail sector.

Franchises are generally retail businesses, but not always. Somehow they are less volatile in their value than other retail operations, for reason only of the perception being that they are part of a stable operation, and have huge marketing budgets behind them. In difficult times their undercapitalised competitors go to the wall, reducing the number of slices the pie needs to be cut up into, even if it is a smaller pie.

There is another albatross following franchisees, viz. the franchisor and his debtors department. This is a sting in the tail of franchisees’ income statements, particularly where the franchisors do not reciprocate the royalty and marketing fund contributions with a strong brand, and even stronger marketing effort. The effect of this comes to the fore in tough times. When strong stand alone businesses are able to net less than 5% of their sales, outlets of weak franchise systems are contributing all of this to their overlords. So where strong franchise systems command good multiples, their weak counterparts do not.

We will unpack this some more, later in the series, but for now, I hope I have illustrated how foolhardy it is to compare notes with friends in other industries, using the multiples they achieved in the sale of their businesses which may have been in an entirely different industry, different geography, different economic cycle, different … etc.

Valuation indicators Type of business (part1)

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For many years, the obvious question we would ask all our prospective buyers of businesses, is what business each would like to buy; that is, if they didn’t open the dialogue with a statement like “Hi, I’m looking for a small restaurant / coffee shop / factory / workshop” – the standard greeting from buyers in our industry!

Everyone has his favourite, and equally everyone has his pet hate:

  • Factory owners hate the idea of retail food outlets.
  • Retail food franchisees don’t see why they should have to work as hard as a factory owner. (Their perception, not mine)
  • Retailers tell me how they don’t want to call on their customers – “They must come to me”
  • Agents are happy to rent small offices, employ a few people, and move boxes. Preferably from home.

And it is this difference in favourites, coupled to an ever-changing macro-economic environment which contributes to the differences in values from one sector to another, from one time to another.

The old maxim of “if you have no shop, you have no business” is true for retailers, more so than it is for factories, for instance. Retailers in the small and medium size stratum are notoriously short sighted, in the opinion of almost everybody else. Most retailers are at the mercy of their landlords to start with, and are more often that not, abused by these wily foxes.

The big retailers can swing enough clout to turn the tables and have the landlords at their beck and call, while the small guy must simply take everything that is thrown at him from enforced opening and closing times to arbitrary rule changes, usually at the insistence of a much bigger retailer.

Of course, becoming a small retailer has enough of its own hurdles to overcome, that it’s a wonder that there are any of them in the bigger centres at all. Personal suretyships as well as bank guarantees often accompany the inflated rentals which subsidise the much lower rentals paid by their bigger colleagues in the anchor positions.

In difficult economic times, the small retailers are taken out quickly, and we were inundated with requests to sell “for almost anything” over night. So, retail values plummeted. As times improve though, the buyers of retail operations flood into the market to purchase the very few available businesses still operating after the squeeze. Demand drives prices up in a market being held dear by now cash flush owners.

Demand for retail businesses in good times is high, because most small operations are easy to run, and usually don’t require any specialist training. Entry level buyers from the ranks of the recently retired, retrenched or stressed are the fuel that feeds this machine.

During 2006 we saw a major shift in value from the factory environment to retail because of BBBEE initiatives being brought to bear on factory and wholesale businesses. White people unable to stomach the idea of sharing their businesses sold up and moved to retail where the same pressures did not exist. With the nexy round of codes of practice being released in 2007, this trend reversed with the perceived diminished BEE risk, and retailers suffered as the move to manufacture strengthened.

The fall in retail value was cushioned by the rise in consumer spending with the credit largess of that year and 2008. Big spending led to high profits, which attracted high rentals from more and more shopping centres and strip malls opening.

Came the end of 2008 and the so called “credit crisis”: many, many small and medium size retailers fell off the wagon and placed themselves on the market. A flood of supply of businesses attracting few buyers. None of those sellers had pre-approved credit facilities. The combination led to a general plummet in retail value.

So the first to feel the heat as the global credit crunch took hold were the retailers, with many of the buyers of 2007 and early 2008 now closing shop, unable to sell. That was first true for luxury item stores and fast food centres. One trendy night spot franchise in  particular, had as many as 38 of its franchisee operations for sale in 2009.

With a rise in supply and a fall in demand of any income producing entity, comes an associated fall in any of the multipliers which indicate its value. With a fall in profits, there is a magnified effect on the fall in values.

From all this it is easy to understand the high amplitude and frequency of value change in retail operations from extremely low profit multiples in poor times to frankly stupid multiples in good times. “Stupid”, because it is these new owners who will be taken out in the next downturn.

Prepaired

In all my years of helping people to sell their businesses, the biggest frustration was not in finding buyers. There is never any shortage of people wanting to own good, profitable, well prepared businesses.

The real frustration always came in when the would-be owner had to find funding to enable the deal. The seller was faced with a choice:

  1. Look for alternative buyers while the one in hand seeks funding
  2. Wait for the current buyer to find his funding

I generally recommended the first option, in a low key, non threatening (to the buyer) manner. Problems arose if the buyer found out his deal was threatened, which often resulted in him losing motivation to carry through with the project. Similarly, funders insisted on exclusivity for a period while they conducted their due diligences. If, as often happened, the business passed muster, but the buyer did not, the deal failed. We were left looking for another buyer anyway, as if we had waited on option 2.

Taking the funding on offer from buyer 1’s bank often helped subsequent, more suitable buyers, if the seller stayed the course.

Cars

If you ever go into a car dealership to buy a car, as soon as you have got through all the salesman bluster, and shown your buy signal, and you have chosen your colour, seats, extras and so on, you will be ushered to the financing “department”.

Of course this is not a department of the dealership, necessarily. In reality, the “department” is an individual who is a bank clerk with a desk at a dealership. The bank has previously vetted the product and the dealership. Of principal interest to the dealership and the bank now is the viability of the customer – you.

White goods

Similarly for cars, the customer is shown a seat at the “finance desk” of the department store selling washing machines, TVs, laptops, smartphones, and so on. Things are a bit different for these goods because often the financing of the goods sold contributes significantly to the bottom line of the parent company, for reasons which have become abundantly clear over recent times.

Never the less, the metaphor(ish) holds: Goods and services stay sold if the funding is easy to come by. The funding is product approved in advance by the funder, subject only to a suitable buyer.

So why are business sales not pre-approved for funding?

Well they are, and they can be. It is not as simple as the process of a bank getting into bed with a car dealership group, but it can be done.

Our PrepareYourBusinessForSale™ initiative has been expanded into its obvious next step… being “PREPAIRED”. It is a process which takes time and is not easy to wedge into a fixed algorithm, given the complex differences between different businesses. But a guided and considered approach can achieve remarkably rewarding results.

Speak to possible funders of your exit plan well in advance, and get a feel for what they are going to require in

  • Your business
  • The new owner
  • The deal structure
  • The deal value

Keep in mind that you will have to work with your funder in placing the correct new owner, when the time comes.

“I am just so sick of the uncertainty. My business is really doing well, and it has some good years ahead of it, so it is time to get ‘Prepaired’”.

The coming tsunami

The thing with Tsunami warnings is that they appear over and over again following reports of earth quakes, but they seldom manifest in anything discernible to those on the shore. So with time, people, cities, and governments start to ignore the warnings. Frogs in warming water.

When the big event occurs. The unprepared citizens witness first hand entire towns being washed off the face of the coast, nuclear power stations being shut down, or not. And vending machines being left unlooted. This was once a real thing in a first world country.

My South African clients are giving giving vent to any number of local scenarios, ranging between two extremes:

  • Zuma will be out by Christmas, and in jail by the new year (Unlikely)
  • All is lost, the country has been entirely captured. Democracy is a myth in South Africa. Stock up on canned goods and buy Bitcoin. (Also unlikely, although I do find myself attracted by the notion of a finite issue, decentralised, non fiat, digital asset)

We all have our own expectations of the future, and our actions or inactions will be influenced by the current turmoil in the political, social, and economic malaise; but that malaise is the single biggest reason for so many of our clients retaining us in the last year.

As Stephen Grootes says:
“The next five months in our politics could determine the coming decade”.

As luck would have it for those approaching retirement in the near future; there is a growing number of investors looking to expand their own projects into business owners’ horizontals and, or, verticals. They are getting their own acts together for a strong upturn which is quite possible, once the madness is over.

  1. Horizontals – competitors, industry related, and complementary businesses.
    A franchisee in a successful chain of restaurants buys a store of the same franchise which becomes available on the other side of town, and also makes an offer for the new store being contemplated in the new mall.
    A hairdresser buys a nail salon in the same mall so that it can cross sell to both businesses’ customers.
  2. Verticals – in the same supply chain to an end user.
    A large group owning a logistics company, an abattoir, and a coffee bean importer, purchases a national chain of restaurants to enable spare capacity in the abattoir and the logistics businesses to be utilised, while securing a market for its beans.
    The supplier of beauty products buys both the hairdresser and the nail salon so that it can benefit from gross margins on a longer chain.

The potential investment situation is evidenced by the large amount of money sitting unused in large businesses, corporates, and in pension funds. It is the same money which Bell Pottinger might suggest is being held ransom by white monopoly capital (WMC) – an apparent thing – for defined performance by the ruling elite.

Psst… it is money being held back looking for decent investment. Stop being a box!

As a business owner entering the closing years of an exit plan, you have an unprecedented opportunity to tap into that enormous resource; but only if you play your cards right. PrepareYourBusinessForSale™. Get prepaired. The group or company which buys your business is not going to pay over the top. They will pay the value you are able to confidently demonstrate. It’s up to you to demonstrate that value. If you are not adequately prepared, you will leave money on the table.

Think outside the box for a while. Really; give it some serious thought:

  • Who would be interested in buying your business in the coming years?
  • What would they want to buy?
  • Does your business have the capacity to excite, simplify, or add security to a new owner?
  • How do you get things in the right “place” for them?
  • How do you maximise your own value, while enticing the acquiring person / business / group to see the greater future picture?

Those are the current and ongoing challenges for all business owners. Don’t neglect them.

Pitch Deck 02 Suppliers

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Risky business The ultimate sale of your business is a risky thing for that business. Sellers either realise this and react accordingly, or they give it no thought at all and blunder into a mass dissemination of previously guarded intellectual property – a course which will damage the business in the future, for whoever owns it.

You need to be wary of how you present the information given to potential buyers, some of whom are not as honest as we would like them to be. Consider two different businesses:

  • The owner of a small supermarket on the one hand, with his very wide range of suppliers, all well known in the market place; and on the other hand
  • A niche manufacturer of specialized components to the mine drilling fraternity who purchases wear components to fit to his patented head.

The sensitivity of the latter is much higher. In a meeting with the former, and the owner of another supermarket who is looking to invest in other ventures, the conversation might sound like this: “Do you buy direct from Liger Brands, or do you go through the DC? When you deal with Liger, you should ask to speak to the new guy Louis – much more helpful than Joe.”

The niche manufacturer will be far more guarded in even telling the prospect that he imports his components from China, let alone the name of the supplier. These details are more likely to come out through a due diligence process after the deal is signed.

Open up and die

An example: We were involved in the sale of a motorcycle parts wholesaler which had run into cash flow problems associated with rapid growth and a depreciating currency. (At one time they were selling older inventory at the same price as the new replacement goods were costing them – how’s that for a business model? But that’s another story.) The business had sole agencies for a number of lines, and general agencies for others. They had prepared tables of information on gross margins, sales trends and flow through profits. The prospective purchasers were appreciative, and through the process there was a short tussle between two buyers to become the new shareholder of the business. Eventually it was sold to the higher bidder.

But midway through the process a very well established motorcycle wholesaler entered the fray. The so called “ideal purchaser”. This was very exciting for our client. Then I calmed the waters by asking if it would be usual to supply this information to other competitors. Would it be okay for us to tell Biglad Biker Bloke (BBB) what the margins were on a product we supplied to them; but more than that, to tell them what our sales on that product had been for the past three years? Well of course not. Imagine how upset would another prospect be once the sale had gone through, and he discovers that BBB has had access to the same data he had, and is now using it to force prices down.

Would you normally supply market sensitive data to a competitor?

The situation resolved itself when BBB told us that they were only interested in some of the brands (the most profitable, no doubt) and would be retrenching all the staff in the transfer.  That was the end of that negotiation. More on this in a later instalment.

Non disclosure agreement (NDA)

An important question: If the prospective purchaser picks up the telephone and calls your supplier; how much damage will be done when the supplier discovers your business is for sale? This is an issue which needs to be dealt with by the M&A practitioner guiding you in the sale of your business, and should be dealt with in the non disclosure agreement signed by prospective purchasers prior to even the name of your business being supplied.

In the meantime, the advice here is to limit your output of supplier information in your Pitch Deck to fairly innocuous generic information to start with. Wait until you have a better idea of who you are dealing with, and what their intentions are. A lot of this information can be provided in subsequent handouts, and even as a generic “promise” to be proven with the due diligence.

Bus number

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What is your bus number?

“But Honey, if I get hit by a bus, this life insurance policy will make sure that you and the kids are looked after”. We have all asked the question, or contemplated the ramifications of someone being hit by the proverbial bus.

Lourens Coetzer, a very bright computer genius, turned this around in a discussion we were having recently, and coined the measure “bus number”: The number of people in an organisation which, them all being hit by a bus, it would take to destroy a business.

A stand alone, one man self employed operation obviously has a bus number of 1. Any employee, no matter what he does, and how he earns his crust, has a bus number of 1. Standard Bank has a bus number of hundreds, maybe even thousands, we would think. But what if all the tech wizards were wiped out in a bomb blast at the annual prize giving? That bus number might only be 20.

{Ed: that seems a bit extreme. At least some of the techs would be in the hydrangeas smoking weed.}

More than considering how many people any particular enterprise is able to lose to the bus, it appears that the crucial bus number needs to be considered at the weakest point in the enterprise.

  • The business is entirely dependent on its sales staff to keep the machinery running, with a short lead time, and there is a single rainmaker making up that sales team – the bus number is very low.
  • The sales department is diversified and competitive – the bus number is high.
  • The business is a professional practice – the bus number is determined by the number of competent professionals.
  • A single CAD designer distributing work to a group of machine operators…
  • Software developers in a disorganised or poorly documented project…
  • That single black shareholder/director upon whom the enterprise depends for its BEE score, now that the government appears to be abandoning its “once empowered, always empowered principle.

That quick list demonstrates how tenuous is the grip SMMEs have on their futures, and it is worrying in the present, but even more so in the future, where business values depend on the sustainability of the enterprise.

So the challenge is to raise your bus number, to account for the systems and redundancies built into your business. It is unlikely that any reasonably sized, privately owned business would have a bus number above 3.

  • The owner or CEO, the financial manager and the factory manager
  • The owner or CEO, the sales director and the factory manager
  • Just, the top three sales people

As we develop Lourens’ concept label, all sorts of derivatives spring to mind:

  • Bus number as a proportion of all employees
  • Bus number per turnover
  • Bus number as a proportion of training budget
  • Bus number critical point of failure!
  • Bus number replacement lead time

And as we reconsider the example of the empowerment score card bus number, it appears that ministerial interference is once again threatening the future values of our businesses, with random brain emissions. Thank you, Minister Zwane.

Failing to plan? Planning to fail?

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Brian Tracy said “ Failing to plan means planning to fail”
In the mad rush to increase turnover in the run up to a sale, the very essence of the business is often ignored – its raison d’etre: The bottom line and the sustainability thereof.

The formula seems simple: Raise the sales, cut the expenses any way you can, show a magnificent profit; sell to some greedy purchaser.
Unfortunately it is not this simple for a number of reasons.

  • Good quality business buyers and investors always make their agreements of sale subject to a suspensive condition of sale (or condition precedent) in which they require to be satisfied as to the state of the financials as well as satisfactory answers to a lengthy due diligence questionnaire which they will have formulated over several years. During this process they will look for sustainability.
  • Businesses do not always sell quickly. In fact very often they take a long time to be sold, and during that period they will need to be sustained themselves, for themselves. There is no clause which allows a business to deteriorate during the due diligence and financing phases but which still locks in the purchaser. (Well I suppose there is, but you’ll struggle to get a buyer to sign it.)
  • Businesses need to grow, but at the same time remain sustainable and fundable. Uncontrolled growth sucks up cash flow better than any super sopper mopper you have ever seen. With an impending sale looming, quick last minute growth will sound the death knell for most sellers.

As with so many things of any value in life, businesses need to grow in value in a well structured and planned way which takes time and patience, and they need to have the following elements in place:

  • Sales, margins and profits
  • Infrastructure
  • Intellectual property
  • Sustainability
  • Balance sheet

Sacrificing margin to grow sales helps nobody but the psychologists. Raising sales through good marketing efforts while maintaining margin is great. Great that is, as long as your infrastructure is in place to sustain the delivery to customers. But very often, the infrastructure spend bites into the profit line. Worse than that, spending on more staff and the delegation of responsibilities can also bite into the intellectual property of a business, and where the barrier to entry is very low, even bigger problems can arise.

Strangling a business through ensuring sustainability without pushing the risks a bit will ensure that you have a boring stagnating venture that you wish to sell, if only to stop the boredom.

Planning makes the difference.

Just as planning for the sale of a business will make an enormous difference to your life when the sale happens, so planning the growth of the business beyond just adding sales to the top line will allow the business to grow in a controlled manner rather than in fits and starts of feast followed by cash flow crisis. Your added sales may bolster your cash flow initially, but where will your inventory come from, and who will finance it, pack it and ship it? Who will provide the extra after sales service and explain to the greater number of customers how the widgets work? How will you collect the money, account for it and bank it? And how will you survive in the meantime?

Working through bottle necks in advance will not only save you a lot of grey hair, but will also add value to the business long before you have to, or want to sell it. Of course the added benefit is that you get to enjoy stronger cash flows while you still own the business.

Valuation Myths Value is based on turnover

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“Turnover is vanity, profit is sanity and cash flow is reality.” We’ve all heard it said, but a huge number of people have never taken it in, thought it through or understood it.

From time to time we will do some marketing to get some fresh blood into the network; and as the phone starts to ring, we are quick to recognize the “buyers” who have no real understanding as they ask: “What is the turnover?”

You see it does not matter, as a general rule. Of course there are exceptions like petrol stations and supermarkets, both of which work under a fairly standard set of parameters, understood intimately by their operators.

But when it comes to most businesses which battle from day to day to maximise their sales, while buying in their stock as low as possible, and minimizing their expenses, turnover is limited in relevance to calculating the VAT and commissions, and setting records to be graphed on a wall in the owner’s office, usually behind the door.

When it comes to valuing a business, turnover has no importance at all, except to point us in a direction of the business’s growth, and even this can be misleading. When we value a business, our model draws lots of graphs to identify the places that managers of businesses may be going wrong, and one of the anomalies we often see is a sudden rise in turnover coinciding with a fall in gross profit percentage. The inference to be drawn is that the business owner is “purchasing” sales turnover in order to impress someone, usually a hoped for purchaser of the business.

If things are well planned and fixed expenses are rationalised, this may lead to greater profits, but more often than not, the “sale month” leads to lower profits, and the result is exactly opposite to what was intended: Value falls.

Here is the simple calculation:

Two businesses in different cities, manufacturing the same goods with the same turnover and similar expenses, but one has lower cost of sales because it is closer to its principal suppliers.  It has an immediate advantage with stronger cash flows, and after paying the same expenses as its counter part, ends up with more profit.

Given the opportunity and inclination to buy either business, which one would an investor choose? Well the more profitable one of course. And if there were several investors in the same room, there would be a bidding war, and the price would go up, as the less profitable business is ignored.

Does that make sense? Of course it does. Now stop asking about turnover in valuing your business, and concentrate on the net profit and the benefit you really get out of the business as the owner.