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

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Does your business need an auditor?

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Does your business need to be audited?

  • Perhaps your memorandum of incorporation or shareholder agreement insists on an audit.
  • Perhaps your business is within certain industries which require one.
  • Perhaps your funders require an auditor’s report annually.
  • Or perhaps you believe still, that all companies need to be audited?

If your PIS falls below 350, you do not need to be audited, and you may be wasting a great deal of money on the annual event.

Oh, but perhaps, just because a firm of auditors send an accountant around to your business every year, you believe you are being audited. Perhaps you are simply being reviewed.

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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.

Business owners under the bus

The 2016/17 budget came and went without too much concern from tax payers, given they were all expecting a much harsher tax collection regime. The media in their quest to sell their advertising have concentrated on the effects to their readership because, let’s face it, they need to attract as many interested eyes as possible. I have looked, and seen nothing about how business owners, big or small have been affected. There is nothing I can find, written about how as of now, business owners have become a lot poorer, at the stroke of a pen.

First some history

When capital gains tax (CGT) was introduced in October 2001, there was a lot of panic in the business community about what was perceived to be a crippling tax on the sale of a business. Those fears were reduced to a certain extent by a few apparent concessions from SARS:

  • Businesses could have their businesses valued by a competent authority as at October 2001, which valuation could be used as a base from which the gain would be calculated.
  • Businesses could use their actual acquisition or establishment costs as the base.
  • There was a prorata base for calculating the gain as  well

When the selling event occurred, the business or the owner, could work all three calculations, and use the most beneficial one for his payment of CGT. Crucially, only a portion of the gain was then taxed – 20% for individuals at their marginal rate and 50% for companies at the corporate rate.

That was all good and well. Business owners looked at their valuations, thought about what they could get for their businesses, and realised that the tax payable would be negligible. So they moved on. CGT was relegated from a panic to a mere irritation.

A few years later, business sellers were receiving a bit more on the sale than they had expected, but the CGT tax although payable, was also very bearable.

Something like this: A business selling for R1.2M, with a base rate of R1M, had a gain of R200k. For companies selling the business in an asset deal, the applicable CGT was 50% of R200k = 100k, taxed at 30% (as the corporate rate was then), meant a total CGT of R30K was payable. But for the company owner to get the money into his own pocket, he would have to pay secondary tax on companies of 12.5%. That works out to another R146,250 going to the tax man. The owner walked away with R1,023,750, having paid almost 15% of his selling price to SARS. The CGT implication was dwarfed by, and therefore lost against, the much larger STC.

If the business owner chose rather to sell his shares in the company in the same deal, the tax would have worked out like this: The gain of R200k would have 20% subjected to the CGT, so R40k, and assuming he was at the top tax bracket of 40%, the tax payable would have been R16k or 1.3% of the selling price of the shares.

If the seller was over 55, the first R900k of the gain was not subject to any CGT, and for this example, no tax would be payable.

So why then did business owners not go for the equity deal, rather than the asset deal?

Some essential practical background

In years gone by, business owners were more (how should I put this?) “interested in making profits than doing their paperwork properly”. This left a potential problem of risk in the company (or usually, the close corporation) housing the business. If the owner sold the company as a whole (ie, the shares or equity in the company) the new owner could find himself having to deal with a bunch of skeletons, which often came with crippling price tags. He would then be faced with the prospect of suing an untraceable seller.

So the buyer would prefer to move the assets, the goodwill, the customers, the supplier contracts, the staff, and whatever else as required, into a new company (Newco).

The seller found favour in this arrangement as well, because he knew that almost every bit of paper he had signed on behalf of the company in the past, included a clause tying himself up to the deal in his personal capacity, jointly and severally with the company.

The deal was protected by a clause in the insolvency act – section 34, and some advertising that was done in the press, which nobody ever read.

For many years, that was the way of dong things. I would tell buyers and sellers: “Consider the pros and cons of whether to do the deal as an asset deal or as an equity deal. Then just do the asset deal”. It was the accepted wisdom amongst all professionals in the industry… Despite the extra tax payable. Only in exceptional cases was the equity sale route taken.

Buyers forced sellers to go with the asset deal. Sellers were comfortable with the 15% tax, and took comfort in the protection the structure gave them.

It gave us at Suitegum the idea to launch PrepareYourBusinessForSale™, allowing business owners to take the risk out of the sale of their businesses, gain more value, and save tax. At the same time controlling the inevitable due diligence process, to give greater comfort to the buyer of the business.

Time marches on

Let’s move on by 11 years. You all know about the magic of compound interest –  the greatest force known to man, and all that? Well it turns out that it is not only relevant to interest on interest compounded on your savings bank account.

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The same principle holds for other growth indices, most notably felt through the effects of inflation. But even more pertinently to this conversation, the concept holds for the value of businesses. It holds to such an extent that those valuation exercises done in 2001 on businesses which are being sold today, are of almost no consequence at all in reducing the CGT payable.

If your business is older than 15 years, chances are that shareholders have changed in that time, making calculations awkward, the original base value number is useless in mitigating the effect, and your business value has grown enormously.

So I am going to do what most people do, and base the rest of this on the single selling price. Your accountants and tax professionals can tidy up the bits and bobs for you.

Along came a bus

Our small (and not so small) business owners – you know the cornerstone of employment opportunities in South Africa – merrily went about their business of keeping their heads above water, and helping the economy on the way.

But then a bus appeared out of nowhere.

In 2012 a change was made to two taxes; you guessed it, CGT was one, but the other one was dividends tax.

  • The gain subject to CGT was moved from 20% to 33.3% for individuals
  • More importantly, for companies, the rate moved from 50% to 66%
  • The old secondary tax on companies was replaced with dividends tax, and the rate was pegged at 15%
  • Let’s not ignore the effects of geometrical growth in business values

Back to our business which was valued at R1M in 2001. By 2012, this business was quite likely worth R10M.

An individual selling his shares for R10M would have his gain of R9M having 33% or R3M taxed at 40%, so would have to pay CGT of R1.20M, or 12% of the selling price. That is quite a difference from the previous 1.3%!

Pity the guy who sold his business in an asset deal: R9M gain having 66% or R5.9M taxed at 28% or R1.7M. His company would be left with 8.3M. To get that into his own hands, he would have to declare a dividend, and pay that tax. So he would have a little south of R7.1M to take home to his long suffering life partner. That is total tax of 29%, which is significantly higher than the guy selling his shares.

At that point we had the attention of those who thought about spending a small amount each month to get their businesses prepared properly for their eventual exits! And PrepareYourBusinessForSale™ started to make a difference.

The bus is reversing

That bus which did such a good job of wiping out a chunk of the small business owner’s well earned wealth?

Well it has now been put into reverse. Not, you understand, to undo the damage previously done, but rather, to finish off the job!

Look at what has happened in the 2016/17 budget.

  • Dividends tax has remained the same, thankfully.
  • CGT on companies has been increased to affect 80% of the gain.
  • CGT on individuals has been increased to 40% of the gain.
  • Business values have grown significantly, only because of the hard work of their owners (mostly).

Our old friend, the business which was valued at R1M way back in 2001, is now worth R15M. Well, because that’s the way the compounding geometrical growth curve rolls.

For the asset deal… A gain of R14M… 80% of this is R11.2M. Taxed at 28% is R3.1M, leaves R11.9M. After dividends tax, the owner can walk off with R10.1M. So a total of R4.9M is paid in tax. That is 33%. Thank you for playing!

For the “more risky” equity deal… The owner of the company sells his shares for R15M, with a gain of R14M, 40% of which is subject to CGT (R5.6M) at 40%, making R2.2M payable to the treasury (15% of the selling price).

What could you do with an extra R2.7M in your pocket?

Anyone?

There is another benefit to the equity deal for a shareholder older than 55: The first R1.8M is now not subject to CGT. That relief is not available for the asset deal.

The point is

The point is that CGT was introduced to us in a fundamentally innocuous manner, with a cynical eye on where it would take us in the future. The future has arrived. Please don’t suggest that there is no wealth tax in South Africa. It is right there.

For companies selling businesses, the rate has moved from something which was hardly worth talking about, to something which is quite astounding, given that for the business to have reached this sort of valuation, it had to spend years paying lots of taxes already. Thank you for that. Those retiring shareholders who get all their money out… I hope you spend it before you die, because if you don’t you’ll be posthumously handing a lot more over to SARS.

For individuals selling their shares, things look a lot less generous to Mr Gordhan, or whoever happens to be minister of finance by the time you read this. But that approach has its risks for both buyer and seller. The good news is that the PrepareYourBusinessForSale™ program mitigates that risk for both sides, and for a fraction of the extra tax you would pay otherwise.

The imperative, ladies and gentlemen, is to sell your business by way of an equity deal. That means you sell your shares with the balance sheet intact. There are some other interesting tax advantages to this approach which you may want to investigate with us, once you have signed up for the PrepareYourBusinessForSale™ preparation.

Some salt for those wounds, Sir?

To add insult to injury… If you want to keep up your BEE score card at its current level, the new codes dictate that there’s a small requirement in that you may have to sell a bunch of shares, and pay CGT on the gain, following the sale of those shares. Oh how they like milking this particular cow!

Heads up everybody: I am not a tax professional. Every single business is different. In our PrepareYourBusinessForSale™ program, participants’ accountants and tax practitioners are engaged with closely, in determining an appropriate strategy for each participant, because there is no “one size fits all” solution. The examples used here are for illustrative purposes only.

Sad realities

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So far this year I have come across three sad stories of exit plans going wrong.

And I am so sorry that the story is yet to be written, and that you have clicked here before it is ready for publication.

My emailer went out a full two days too early. Nobody’s fault except mine.

If you are on my email list you will get notification as soon as it is ready.

 

Through their eyes

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PYBFS011

 

Within the paradigm of always being ready; I as not!

The email link you have probably clicked on to get here was sent out in error. and way too early.

It will be ready in the next few days, and I will notify you again.

Sorry for the inconvenience.

{Note to self…. NEVER allow a newsletter to go out at 6am on a Monday again. What was I thinking?}

Oh wait… I was not thinking.

Redundancy Standard – Bank on this

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One thing that is certain to give you grey hairs at some stage in your business owning life, is the concept of redundancy. If, when things hit fans, you are able to move easily to an alternative supplier or resource, you will have an edge over your competitors, and still be able to deliver to your customers. With minor glitches perhaps, you will be able to maintain your profitability, and hence your business’ value.

I maintain several prepaid SIM cards from different carriers in order to be able to buy some data quickly, in need. In the last year that policy has helped me several times as my primary operator has thrown a fit, or I have found myself at a meeting or conference with poor coverage for my principal carrier.

If your business has only one supplier of a primary service or product, your bank will take a dim view of the business value and risk profile. Particularly if that single supplier can screw up the first day of spring for you. As I originally wrote this, a Standard Bank executive was claiming that everything was back to normal. It was not. “If I can be honest with you….” (like they aren’t always). “We truly apologise… ” (because it’s not always truthful).

Why do we insist on having all our funds and facilities in one bank?

The problem stems from the banks themselves who insist on certain “covenants” if your business has any sort of credit facility with them. Some of those covenants created potential value problems for Standard Bank customers when their electronic banking facilities collapsed for the first few days of September 2014.

So the week 36 little debacle serves to highlight in an inconvenient way how we can fall foul of the very covenants which our various banks insist on, in order to safeguard them.

Try negotiate yourself into a space where you are able to have more than one supplier, including your banking supplier. Just so that if something desperately needs to be paid on the first day of spring, you are able to pay it or (better) receive it.

I have bounced this idea off several clients, friends and banks over the last two weeks. Here are the problems:

  • Your banking covenants forbid you doing so, particularly if you run any sort of credit facilities with the bank
  • There is only so much money to go round
  • You’ve already burned all your bridges at other banks
  • You just couldn’t be bothered

I don’t think any of those are insurmountable. Just do it. We are South Africans. We make plans.

Twitchy buyers

Professional sellers of various products and services use a number of passive and active hard sell tactics to persuade buyers to part with their money, and even put up the price after the fact:

  • “That offer is only available until close of business today”
  • “This is the last one we have in stock, and we don’t know when the next orders arrive”
  • “Calling Mr Otis”*
  • “We have three other buyers”
  • “While stocks last”
  • And many more

So a few weeks ago I wrote here about the high prices for which tech companies tend to be sold. A précis: Twitch is a company which provides live views of gamers’ screens to people that are interested in such things. Google was a talking a $1B deal. I asked about the price of a company that was making no money, and provided some suggestions as to why it would be sold so high.

Suddenly, enter stage left: Amazon, paying $970M cash for the business. It appears that Google may have walked away to avoid anti trust investigations. Perhaps Google was only prepared to pay with their own sky high stock in overcooked shareprice markets.

Whichever way, Amazon blinked because it really needs more revenue (and is ditching Google adverts from its own site in favour of Amazon’s own brand of click through advertising.)

In the new paradigm which Google, Apple, Microsoft and Amazon have created, there will be many more similar deals in the future, as they all seek to either position themselves in line or ahead of the others, or try to take potential competitors out of the mix.

With respect Dear Reader, I suggest that your business is probably not worth this sort of money. But the underlying principles are similar when it comes to selling it one day:

  1. You need to have options
  2. You need to create competition between prospective buyers
  3. You need to know what the realistic value of your business is
  4. You need to understand your buyers’ motivation
  5. You need to be able to negotiate without blinking (or twitching)

Understand the thinking of the business buyers, and your eventual buyer may start the process on the backfoot, without even knowing it. Preparing your business well in advance for the eventual deal will nail the deal down.

 


* “Mr Otis” was a technique used by motor car salesmen in the USA. A now relaxed buyer would settle back in his chair after signing the papers to trade in his old car. He would mention that the next best trade in offer was substantially lower (by $2,000, say). The salesman would wait a minute or so, shuffle the papers, look for his stapler, then say: “We just need to get this signed off by Mr Otis”. He would call his manager on the phone, and say: “Mr Otis, won’t you please come down and meet Mr Buyer?” Being called “Mr Otis” was the manager’s cue for objecting to the offer on the trade in. Of course by that time the buyer was so emotionally invested in the deal, that he could never back out, and he would quickly agree to the lower trade in value. – Lesson 25 in Harvey Mackay’s Swim With The Sharks Without Being Eaten Alive.

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.


Racing to the end of the line

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As the nation has been taken by the interesting behaviour of prominent families in exhuming and re exhuming departed members of the same family, real life has been happening and ending for a bunch of interesting folk – like you and me.

A little more than a week ago two trucks ran into trouble down the steep hill linking Ontdekkers Road to the N1 Western Bypass in Roodepoort. The trucks careered down the hill, dragging smaller passenger vehicles, ripping them and their contents to pieces. One truck jumped the centre island into the path of oncoming traffic. Those oncoming smaller vehicles had been jostling for position from the traffic light around the corner behind them, before the upcoming steep hill, as they always do. When the dust had settled one truck was a mangled wreck and eighteen cars were damaged or destroyed, including a number which had been parked outside the casualty entrance at Flora Clinic, behind a palisade fence.

Four days later, the MEC, who was apparently still counting the injured (yes that’s right) said something had to be done… blah blah blah… the usual too little too late, which ignored the fact that the very permanent traffic speed monitoring camera which had been taken out more than three years previously by another vehicle, had never been replaced.

The last I heard, before the tragedy disappeared from front page reporting, was that five people were dead and eighteen injured. I think it would be fair to say that for the most part, those affected were entirely innocent, simply going about their daily business, as we all do. Imagine their terror as they saw those trucks belting down the hill towards them. If you know the road, you would also know that at the point of impact there is no place to go, despite all your best rehearsed emergency plans.

The distress of victims’ families today, as they deal with the aftermath, is the reason we are encouraged to purchase life and disability insurance. I do not know who any of the victims are, and I can only guess that any of them might be business owners, but let’s just consider for a moment that one of them is (or was) a business owner. For this special person there is another consideration besides the life and disability insurance available to employees. Business owners have an asset in their businesses which many rely on as the source of their future pension.

A good business should hold a great deal of value for the owner or the beneficiaries of his estate after only a few years. The problem is that it can only be realised on the sale of the business or shares of the company.

It’s not as if you can take this asset (worth several millions) to a bank and use it as security for a bridging loan, or use it in its raw form to purchase an annuity. Selling in tragic circumstances almost never gives the seller anything close to fair value. A big part of the unfairness revolves around vulture buyers, sure; but even sadder for the survivors is that the unconscious or dead owner has left very little by way of clues as to where to find the “stuff” which gives value to the business – mostly because most of them don’t know what dictates value.

You can be quite sure that vulture buyers will spend a great deal of time harping on all the negatives in the business to your already distressed family. So while we can quite rightly complain and whine vociferously about politicians and local government officials, we as small business owners are very often our own worst enemies in supporting the value of this precious asset, we call “our business”.

As a mergers and acquisition practitioner who generally represents sellers of businesses, it often falls to me to try explain to widows and orphans why the business which has always provided for their every need is not worth what it should be, simply for the fact that we have so little to work with. The crazy thing about the very easy solution to the problem is that all the answers are usually in the heads of business owners while they’re alive and kicking. They just don’t bother to invest only a little bit of time into securing their families’ well being.

Amongst the most basic requirements are the following:

  • Knowing accurately, what the real market value of a business is; not the braaivleis valuation which is more often than not, very wrong. It is disastrous to find out too late that the business worth half of what you were counting on.
  • Filing in one place, ALL the statutory requirements of the business.
  • Making provision in your will for the continuance of the business, making provision for the sale of it if necessary.
  • Knowing yourself what impact your business’s particular supplier, customer and staff mix has on its value, and having in place a strategy to strengthen any weaknesses which may exist.
  • Understanding all the exposures of your particular business, and how each impacts on the value.
  • Realising that there is a well-defined, internationally recognised calculation of “goodwill”, and that it has nothing to do with multiplying anything by anything else, despite what a beer filled braai buddy might tell you. He won’t be around to pick up the pieces at crunch time.

It is these issues and others which will be addressed at an (almost) free seminar in Sandton on 18 July 2013 at 7pm.

Many aspects of the previous PrepareYourBusinessForSale™ seminar will be included, plus a whole lot more. In particular, I am asked so frequently about valuing  businesses, that a large portion of the seminar will be dedicated to this.

I hope to see you there

 

Why do I say “almost free”? 18 July is widely recognised as Mandela Day. It is Nelson Mandela’s birthday. On that day people are encouraged to do something in service of the community, for free, for 67 minutes – one measly minute for year Mandela gave to public service. So I am presenting this seminar for free on that evening, although the time is likely to be about three times the required minutes, by necessity. All the administration, teas, coffee etc will also be donated, as will the venue. But I am cognisant of the low esteem of “something for free”, so I am asking every attendee to donate at least R380 to the Vula Program.

All donations will be paid directly to Vula by attendees, and section 18A certificates will be issued for tax and BEE purposes by Vula. Once you complete the form and register, you will need to look for registration confirmation in your email inbox. You will then receive banking details and further correspondence regarding the evening.

 

Middle management cripples

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Last week I sat with a client helping him to assess the value of his business. His is a very smart retail operation. Successful retail stores go into the valuation process a few yards ahead of their similarly profitable manufacturing and wholesaler cousins because their risk associated with customers is hugely spread. In a popular shopping centre they are pretty much guaranteed a wide variety of clientele. All the better if the retailer is also part of a successful franchise group.

Retail customers are less worried about the socially engineered aspects of our society like skin colour of the owners and management, and more worried about the reality of quality, service and price. Mess with any of those definitives and the business has a problem which is soon seen in the income statement, and ultimately the core business value.

The downside of the retail trade is in the big suppliers; banks, landlords and franchisor masters. The typical new franchisee sees herself as stepping out into the world of entrepreneurship. Nothing can be further from the truth. Frankly, franchisors do not see their new franchisees as entrepreneurs. At best, the owner franchisee can hope to become a variation of the middle management level in a larger organisation similar to that from which she recently exited. The abuse is no less severe, except that there is no simple resignation, no CCMA dispute procedure and no early retirement. Once you’re in, it’s going to be for a while.

Abuse? Yip. “These are the rules, and they will be policed by mystery, faceless shoppers and the more overt local representatives”. Penalties are related in one way or another to the bottom line. And therefore the value of the business.

“The store will be revamped every three to five years, in line with latest marketing concept, and this revamp is for your account.”

The landlord presents quite another problem: He has a shopping centre to run, and expects to turn a profit. He knows that he has the franchisee locked in. So while there was a status quo which sold to the new franchisee and tenant five years ago, it becomes something of a movable feast. When it becomes obvious that charging for parking is a great way of gearing one’s investment in the property; well why the hell not? The South African consumer has proven himself extremely accepting of all sorts of salami takings from his disposable income. so charge for that parking!

With investment made in parking bays, ticket billing and the rest, more money can be made by getting them to work for longer. An empty parking bay at midnight is fairly useless, but a full one at 8pm is great. So let’s force shops to remain open to 9pm. The landlord makes more money from a few more parked cars for a few more hours, at very little extra cost. But not many people want their hair done at dinner time, nor do people generally want to have a dinner with their family at a coffee shop. But these guys have to stay open, pay staff, run up unproductive electricity bills on unwelcomed air conditioners, display lighting, music, televisions and so on.

For the small franchise owner, well she probably got into this mess by putting the family home on the line on day 1. In the five years since, that loan has been serviced and reduced, the interest having been a major expense. With that light of value gain and much reduced loan repayment fast growing at the end of the tunnel, she gets an unwelcome wakeup call:

While all other business types have been careful to sit on their profits over the last five years, cautious in the continued uncertainty of what the economy holds for us, the landlord, the franchisor and the bank need to generate cash.

The franchisor exercises his insistence on having the store refurbished. This will almost certainly be an expensive exercise. Probably in the region of R500,000. That is serious dosh for the franchisee. She knows she can access it with the renewed security of her home, but heck, what does this franchisor ever do for her anyway? The opportunities in defranchising suddenly beckon with a glint in the eye and a crooked smile.

So off to the landlord she gaily trips. The lease is up for renewal anyway, and the franchisor had nothing to do with negotiating the lease apart from finding the space.

“Absolutely no way”, says the landlord. “We want a franchise coffee shop in that space. If you defranchise, we will not renew your lease”.

Without a lease, any retail operation has no business worth anything at all .

So options and the future suddenly look bleak. If she parts company with the franchisor, the landlord cuts her off at the knees, and she loses the lot. To raise the required funds for the refurbishment means tying up her house for another five years. The franchisor is secure, the landlord is secure. The bank will be secure. She will work. Perhaps she can delay bringing in that new manager who would have allowed her some spare time…

Wait… What if she sells? Surely this place is worth something by now. Then she can buy a real business with the proceeds of the sale. But here too, are issues.

The broker who sells the business is going to be charging a commission for the job. Of course it’s possible to sell without an agent, although that often results in a below par price. Further to that, the franchise agreement revolves around two other ambush items: The franchisor has to approve the new sucker, and will charge what is called “key money” to him.

Then there is the continued question of that refurbishment. This still has to happen. So here’s the thing: Any buyer with any advice will have an idea of what the business is worth, and this value includes all costs of entry. So that R500,000 is in the value, and so is the key money. The buyer will look for a return on his entire investment.

While independent businesses are able to keep their powder dry, and decide when they intend to pay for new signs and livery, she has to pay for the flipping refurbishment, no matter which way she slices this cake.

Talk about being trapped in a job!

The reliance on suppliers this franchisee has, as a retail operation generally, and a franchise operation in particular is a crippling one. And this ladies and gentlemen, is a fairly typical story in the retail franchise game. When you line up to buy one, the best and greatest in the group will be wheeled out for you to oggle over – the top ten percent – because that is who you want to be compared against.