Maximising Business Value Before Exit

A Value Consulting Approach

Richard Trafford CVA

Maximising Business Value Before Exit

A Value Consulting Approach

Richard Trafford CVA

Agenda

• What is business value?

• What issues impact the level of business value?

• Nature of risk and how to manage it

• The seller’s context

• Buyer’s perspective

Any ideas generated here should be discussed with your financial advisers before proceeding.

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What is Business Value?

• The value of any asset is the present value of expected future cash flows

Value of business =

gkFCF

e 1

Owners’ cash flow benefits next year

Required Rate of return

Cash change over time i.e. grow or decrease

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What is Business Value?

• The value of any asset is the present value of expected future cash flows.

All future and (hopefully) growing cash flows for the owner

Time return + risk return

Where risk is uncertaintyWhere cash flows for the owner are economic

benefits

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What is Business Value?

• The value of any business will vary directly with its expected level of economic benefit and the expected growth of such benefits.

• The value will vary inversely with the riskiness of that anticipated economic benefit stream because the increase in risk demands a higher rate of return.

• Assuming no change in the first two variables, reducing the risk attributes of a business will increase its value.

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What is Business Value?

• Less risk = more value

•More cash flows for the owners = more value

•More risk = less value

•Less cash flows for the owners = less value

•Risk is about uncertainty of future results and is classified broadly as either systematic or unsystematic

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Operational Examples

Issues of unsystematic risk

Transparency enables a future vision for the buyer and less risk

• Stable workforce• Good managers• Systemised working• Good controls – operational and financial• Widespread customer base• Strong supplier relationships• Capacity to expand• Low reliance on individual members of the team – management depth

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Operational ExamplesMethod to Articulate Unsystematic Risk (Black & Green, 1991)

Specific Company Risk Factors Incremental Risk %

Operating history, volatility of revenues and earningsLack of management depthLack of access to capital resourcesOver reliance on key personsLack of size and geographic diversificationLack of customer diversificationLack of marketing resources in light of competitionLack of purchasing power and other economies of scale Lack of product and market development resourcesOver reliance on vendors/suppliersLimitations on distribution systemLimitations on financial reporting and controlsPositive AttributesLong term contracts with customers, unique product, market nichePatents copyrights franchise rights and proprietary productsNet increase to discount rate

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Financial Analysis

Two firms with varying net income paths over time

Which firm will have the higher value?

Firm A Firm B

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Financial Analysis

• A complete reflective review of the financial results will assist in many ways, for example:

It will help to identify strengths and weaknesses of the business, relative to itself at any point in time.

It will identify trends of the business relative to the business itself.

It will allow us to compare and analyse the business’ historical performance. Thereby, providing a basis for comparing the business to other similar businesses or industry averages.

Identify areas for potential normalising adjustments.

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Selling Context

• After perhaps spending a lifetime building a business, some owners, due to a lack of planning, do not have a business that can be sold for an optimised price.

• Planning for the sale event needs to take place some time before the event.

• One area that needs consideration is the process of “normalisation” for the financials.

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Normalisation

Frequently encountered areas:

• Owner’s and associates salaries

• Rent expenses

• Personal expenses

We should also consider potential adjustments to revenue:• For example revenue streams that are not being sold, in this case we should also extract associated costs

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Normalisation

We must also consider the balance sheet

• Non-operating assets

• Personal assets

• Loans

•Financial statements that do not need adjustment convey reliability and transparency which reduces risk perception

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Comparative Analysis

Diagnostic check of the business compared with guideline companies

Guideline firms:

• Similar market focus• Size and stage of development.• Industry sector

These will provide valuable insight to the seller for maximising value.

Does the subject business align with the industry averages?

The data used will act as a benchmark for performance rather than an indicator of value. • Financial ratios

Identify strengths and weaknesses

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Comparative Analysis

Identify strengths and weaknesses

Strengths:

• Areas where the business is stronger than its competitors. • Analyse to understand why this occurs and whether it is sustainable.

• If it results from intellectual property (IP) – needs protection• Patents, trademarks, formalised relationships

• Strengths may also come from financial structure• Less debt, more cash held, own freeholds rather than rents etc• May be possible to restructure prior to marketing the business

so that value can be extracted before selling for average multiples

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Comparative Analysis

Identify strengths and weaknesses

Weaknesses:

• Areas where the business is weaker than its competitors. • Analyse to identify.• Management then have time before sale to focus on improving

• Classify as improvable or non-improvable• Some weaknesses may indicate presence of potential synergy

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Synergy

Where the acquirer operates in the same sector or market

Potential:The key to the existence of synergy is that the business for sale controls a specialized resource that becomes more valuable if combined with the bidding firm's resources. The specialized resource will vary depending upon the merger:

In horizontal mergers: economies of scale, which reduce costs, or from increased market power, which increases profit margins and sales.

In vertical integration: Primary source of synergy here comes from controlling the chain of production much more completely.

In functional integration: When a firm with strengths in one functional area acquires another firm with strengths in a different functional area, the potential synergy gains arise from exploiting the strengths in these areas.

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Synergy

Who gets the benefits of synergy?

• The sharing of the benefits of synergy among the two parties will depend in large part on whether the selling firm's contribution to the creation of the synergy is unique or easily replaced. If it can be easily replaced, the bulk of the synergy benefits will accrue to the acquiring business. If it is unique, the sharing of benefits needs to be evaluated and negotiated.

• Bradley, Desai and Kim (1988) concluded that the benefits of synergy accrue primarily to the target firms when there are multiple bidders involved in the takeover.

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Housekeeping

Basic ways to increase the value of the business:

• Work to increase profits and cash flow

• Grow sales

• Get systems in place to enable business to run on “autopilot”

• Remove the necessity for owner involvement and decision making i.e. endeavour to negate the “key man/woman” impact.

• If every decision needs the owner then what is being sold?• Personal goodwill is not saleable

• Get detail in order – leases, contracts, employment contracts etc

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The Buyer’s Problems

Reasons for failure –”the winner’s curse”:

• Taken from (Copeland, Koller and Murrin, 1991)

1. Overoptimistic appraisal of market potential2. Overestimation of synergies3. Poor due diligence4. Overbidding5. Poor post-acquisition integration

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The Buyer’s Problems

Due Diligence – Survey• Bain & Company, 2002• 250 international executives within M&A

50% said due diligence processes had failed to uncover major problems

50% found their targets had been dressed up to look better for the deals.

66% said they routinely over-estimated the synergies available Only 30% were satisfied with the rigour of their due diligence

processes

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Due Diligence Frameworks

(Mullins and Thornton, 2007)

• Financial statements Balance sheet: intangible assets, non-current assets

legal title etc, debtors, inventory, loans/debt levels and covenants, lease commitments and covenants, share/ownership structure

Income statement: Margins/cost structure, Payroll, pension funding, travel and entertainment, operating v non-operating activity

Returns: ROE, ROCE, GP Operational and financial risk Don’t forget they represent the past

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Due Diligence Frameworks

(Mullins and Thornton, 2007) continued …

• Facilities and equipment• Utilisation, capacity potential

• Customer relationships• Supplier relationships• Management systems• Human resources• Potential legal liabilities

• Product, employee, environmental• Synergy verification

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Due Diligence Frameworks

(Cullinan, Le Roux and Weddigen, 2004)

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Due Diligence Frameworks

(Cullinan, Le Roux and Weddigen, 2004)

• Evaluating the future

4 ‘C’ s of competition:• Customers• Competitors• Costs• Capabilities/competencies

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Summary of Areas

• What is business value?

• What issues impact the level of business value?

• Nature of risk and how to manage it

• The seller’s context

• Buyer’s perspective

Any ideas generated here should be discussed with your financial advisers before proceeding.

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References

Bradley, M., Desai, A. and Kim, E.H. (1988). Synergistic gains from corporate acquisitions and their division between the stockholders of target and acquiring firms. Journal of Financial Economics, 21(1), 3-40.Copeland, T., Koller, T. and Murrin, J. (1990). Valuation: Measuring and Managing the Value of Companies, Hoboken: John Wiley & Sons.Cullinan, G., Le Roux, J. and Weddigen, R. (2004). When to Walk Away From a Deal. Harvard Business Review, 96-104.Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, Hoboken: John Wiley & Sons. Feldman, S.J. (2005). Principles of Private Firm Valuation, Hoboken: John Wiley & Sons. Mullins, T. and Thornton, B. (2007). The Role of Due Diligence In The Business Valuation Process. Journal of Business & Economics Research, 5(5), 63-69.Perry, J.S. and Herd, T.J. (2004). Mergers and acquisitions: Reducing M&A risk through improved due diligence. Strategy & Leadership, 32(2), 12-19.

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