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Business Valuation factors for M&A

 

The price any purchaser is prepared to pay for a business is likely to be determined by
the profit and cash flow produced from owning the business, and to a lesser degree by the balance sheet worth of the assets.

The importance of adjusted profits
Purchasers of a business usually produce adjusted profit figures for at least the previous financial year, the current one, and two future years.
To value a business on behalf of vendors requires a similar approach, and the professional advisers should present adjusted profit figures to prospective purchasers at the outset.
From the vendor’s standpoint it is worth adjusting profits for the previous three years if this will help to establish a record of rising profits. One-off events which may have significantly reduced profits in a year include:
• A large bad debt as a result of a major customer going into  liquidation
• The costs of relocating a factory, warehouse or office
• A strike affecting deliveries from a key supplier
• The costs arising from major litigation
• The closure of premises or the termination of a product
• The start-up costs associated with entering an overseas market
• Significant redundancy costs
• Lump-sum pension contributions for directors

Additionally there may be other factors which will enhance profits for the new owners, such as:
• the directors being required to accept a reasonable executive salary after the sale, compared with the substantial rewards enjoyed as owners and directors;
• the intention that a director will retire upon the sale of the business and will not need to be replaced;
• the savings arising from the termination of relatives working for the business at inflated salaries;
• the benefits to be gained from recently taken action such as a price
increase, the elimination of a loss making activity; and so on.
It is particularly important that the profits for the previous financial year and the current one are adjusted to show the most favorable picture which can be portrayed accurately.

In the case of the disposal of a division or subsidiary, it is important to adjust the profits by ‘adding back’ charges allocated by the present group which will cease following a disposal. These include a wide range of possible allocated costs such as:
• a group management charge based on a proportion of central staff costs;
• a percentage levy based on sales value for group expenditure, such as research and development or public relations;
• service charges for the use of central departments such as informational technology, payroll and pension administration; and so on.

The reality is that the acquiring company should be able to provide the resources required at a much lower incremental cost than is presently allocated by the existing group. Equally, it must be realized that the overall impact on the profits of the existing group will be significantly larger than the profits reported by the subsidiary. The reason is that in practice it will not be possible to reduce group costs by the amount allocated to the subsidiary. For example, the sale of a subsidiary is unlikely to reduce commensurately the amount which needs to be spent centrally on research  and development or public relations.
Equally, if the aim is to make a realistic assessment of the worth of a business to a purchaser, it would be naive for the acquirer to ignore the extra costs which will be incurred.
Examples of the extra costs which will be taken into account by a prospective purchaser are:
• the appointment of a qualified financial controller to replace an unqualified bookkeeper;
• the need for increased insurance cover;
• increasing some salaries to avoid unacceptable differentials compared with similar staff already employed within the group; and
• additional pension contributions arising from employees joining the group pension scheme.

The acquiring company will take into account opportunities for increased profits as a result of acquiring the business. It is equally important that these are quantified by the vendor as well. Typical opportunities to increase profits are:
• Purchase cost savings as a result of increased purchasing power
• Cross selling the products and services of the acquired company to existing group customers, and vice versa, both at home and overseas
• The rationalization of premises and overhead costs
The aim must be to negotiate a purchase price which reflects a share of the additional value created by the profit opportunities arising from the acquisition to be enjoyed by the vendors.

Cash flow projections
Purchasers will be concerned to make detailed cash flow projections, probably for at least two years forward, as part of the valuation exercise.
Vendors should prepare at least outline cash flow projections as an important part of their own valuation.
Factors which need to be taken into account include:
• the amount of cash to be generated, or injection needed, based on the expected business growth;
• the need for capital expenditure to replace existing assets or to refurbish premises;
• capital expenditure to meet the planned expansion;
• the cash proceeds arising from the sale or redevelopment of surplus assets; and
• cash balances in the balance sheet at present.
When acquiring a service company, on an earn-out deal spread over several years, the cost of deferred payments may be generated out of cash retained by the acquired company. If this type of situation is not quantified, the company may be sold at too low a price.

If there is surplus cash in the company, consideration should be given to the possibility of using it for the tax-effective benefit of the owners, by making lump-sum pension payments or paying a pre-completion dividend.
In a similar way, cash to be generated by the disposal of surplus assets after the sale must be reflected to some degree in the purchase price. One example is the opportunity to dispose of an office because the acquirer has vacant space nearby.

Adjusted balance sheet worth
The most recent and audited balance sheet should be adjusted to reflect the current net asset worth by taking into account:
• the market value of freehold premises; and
• retained profits since the balance sheet date.
current assets such as stock work-in progress and debtors should be adjusted through the profit and loss account, and in the balance sheet as well.

Valuation criteria and factors
Adjusted profits, cash flow forecasts and present balance sheet net asset worth need to be calculated rigorously.
The recent financial performance, current and future year forecasts will be carefully scrutinized by the acquirer as part of the due diligence. Although a deal will have been agreed and reflected in the signed Heads of Agreement by this stage, vendors must be aware that if a shortfall in current year forecast performance looks likely then a lower price will be negotiated. On the other hand, it is important not to understate the current year profit forecast or this will reduce the original offer, so a careful balancing act is required.

It would be wrong to assume, however, that an accurate valuation can be made simply by arithmetic application of financial criteria or formula.
Less quantifiable factors must be taken into account as well.
The financial criteria widely used by purchasers and experienced advisers alike are:
• An earnings-multiple approach
• Discounted cash flow analysis techniques
• Return on investment
• Impact on earnings per share for a listed company making an acquisition
• Net asset backing
• Valuation rules of thumb in the sector

The less easily quantified factors which should be taken into account include:
• Strategic significance or rarity value
• A defensive need to acquire
• Cost rationalization opportunities

 

we consider that that there is much more to valuation than the use of formula  and yardsticks. None the less, rigorous financial analysis is the foundation, to which should be added insight and judgement. What is more, several methods of calculation should be used. It is definitely inadvisable to choose one favorite method of valuation, thereby rejecting other techniques.

Another vital point to emphasis is that the value placed on a given business is likely to be different from one prospective purchaser to the next. The particular valuation will depend on the ability to pay and the incremental benefits to be gained.

 

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