Originally published at http://businessportalglobal.wordpress.com. Please feel free to comment at the original site. Minor alterations were made and the order was changed in this publication.
Running a business comes down to information. In some businesses, every scrap is meticulously recorded. In others every decisions is based on a leaders “gut feel” but at the end of the day, the decisions are all information driven. Sometimes that information is spot on – based on years of experience and accurate modelling – and it leads to optimised decisions. Generally though, this information is sketchy – based on thumb sucks and exuberant hopes – and this leads to decisions that could pose difficulties down the line. This is the fundamental risk of any business.
From a financial point of view the big question should always be, will the expenditure I’m about to undergo improve my bottom line and will it do so soon enough that the strain that it puts on the company won’t send it to the precipice of survival and beyond. If the answer is “yes”, its money well spent, if its “no”… buyer beware. Accountants will have you believe that they've developed a way to lay down that financial information to make it easy to understand and fool proof. But when you’re considering buying into a business or investing in one, you really need management accounts. They show an accurate reflection of the costs and incomes as they happen, of the real value of the assets and the real costs of the liabilities, of which employees are worth their salary and which ones are there for a free ride and of who really wields the power in the company. The also show if the business is seasonal, competitive, lean, diversified and truly profitable. They show you the numbers in the format that the decision makers want them and they give you the best idea of what the state of the business is and why.
Unfortunately management accounts are generally not readily available because the information isn’t collated or because you just don’t have the relationship with the seller that warrants that sort of access and thus we fall back on financials and hope we can interpret them correctly for the industry and that they are not hiding skeletons in the closet. We hope that the market treats us well and that our cash flow can carry our decision to invest.
The BusinessPortal range of websites are trying to change that (excuse the shameless plug). We want to educate the buyer on what information could inform their decision and thereby attract the right sort of buyers. And we want to show the seller what data they really should be collecting, because it’ll probably be in their businesses best interest anyway.
This will be the first of a series of blogs on the information that should be considered with for a thorough due diligence when doing a comprehensive business deal. Conspicuously, it will be based on the format that information can be offered in on the BusinessPortal range of websites with the intention of showing the value and intention of the format. Please note that it is unlikely to be in the sequence that brokers or business owners will choose to release the information to prospective buyers or investors but that all of the information will eventually be useful and necessary for a thorough due diligence.
Let’s start with the standard business information that can generally be seen (in the business advertisement) before any discussions take place, specifically the information on Asking Price, Annual Turnover and Monthly Free Cash Flow (since the rest is pretty self-explanatory and really just narrows down the prospective investors choice based on their location, financial strength, skills and business preferences).
The Asking Price is an indication of the business owners’ idea of the value of the share of the business they are trying to sell. Generally this is an opening offer in a negotiation (though it can be non-negotiable) and it should be based on the perceived value of a business. Valuing a business is a tricky process because there is no correct (or wrong) way of doing it and certainly no standard way to value every business. As long as there’s a reasonable basis for the valuation, almost any factor can be justified to contribute to (or detract from) the value of business. The reason stock market prices are volatile is because no one can settle on a value of the businesses listed. At the end of the day, a business share is worth what someone is willing to pay for it but this will be affected by factors including but not limited to the value of the assets and liabilities the business has, its past performance, its perceived future performance, the people involved in running it, the market it acts in and its susceptibility to macro- and micro- economic forces, its competition and placement in the market, its operational-, sales-, marketing-, HR-, admin- and management processes etc. For bigger companies, it may be worthwhile to calculate value for a lot of these factors but smaller companies often rely on an educated guess and call it “goodwill”. Either way, these factors generally boil down to the risk involved in investing in a business.
One of the strongest indicators of a company’s relative strength in a market is its Annual Turnover. This is the total amount of money a company brings in due to its trading- (and perhaps investment-) activities before any of its costs are deducted. It is by far the easiest way to compare companies’ relative sizes if they are in the same industry. A company with a higher turnover is very likely to have a larger share of the market (of course, issues like the prices of products and/or services come into the calculation). It does, however, not tell you anything about the efficiency and profitability of a business. For that one needs to have a closer look at the Free Cash Flow.
If the cash flow is perpetually positive, the company’s profitable; if its zero it’s just breaking even and if it’s negative it’s making a loss. When a companies making a temporary loss this is not necessarily the worst condition for a buyer. It will mean that the company needs a turnaround but it might also mean that it can be acquired for reasonable value (since a loss-making business would indicate higher risk). Turning businesses around depends on their current efficiency, the skills the new investor might bring to the table as well as the market the business functions in (and perhaps also a little luck).
In the next blog I’ll consider some of the more detailed standard business information that can be made available on the Business Information tab of Business Views on the BusinessPortal range of websites. To get to see some of this information, there already has to be a reasonable rapport between the business owner and prospective investor.
This is the second in a series of blogs on the information required for a thorough due diligence before going into a substantial business deal. As before I’ll continue with the information as it is presented on the BusinessPortal range of websites, continuing with the information on the Business Information tab. This information is more sensitive and restricted by the business representative until a rapport is built with the prospective buyer/investor.
Where a business is based (designated as the Business Environment on the BusinessPortal range of websites) depends on the type of business. You are unlikely to find a manufacturing business in a mall and almost as unlikely to find a high end restaurant in an area without a view or foot traffic. The mantra, “Location, location, location” holds true in business and if the business you’re interested in investing in is not ideally situated to service its customers and to take delivery from its suppliers (or both - depending on the business), it’s missing a trick. The other important thing to look out for in relation to a business’s location is the property leasing conditions. If the business does not own the property it’s on or the property isn’t part of the deal, transferring a lease is often a large hurdle. Generally landlords need to agree with the transfer to allow the sale of a business to go ahead and since new tenants can often be seen as risky (or an opportunity to raise rents considerably) they can pose a significant stumbling block.
When looking at the Supplier- and Client Types one can start to glean information about some of the risks involved in the market one is considering investment in. For instance, if a business is dependent on specialist suppliers or sells to specialist customers, it could be “held to random” over prices of its inputs or fluctuations in the demand for its end product or service. An example of the strength of suppliers would be in the building industry where concrete and steel prices are a huge determinant in the price of the final product. Alternatively, consider the relative safety in demand in restaurants, because all people need to eat (though competition becomes a bigger risk factor here).
Most businesses need to comply with some legal regulations that govern the industry they function in. Since this applies to all businesses in an industry, confirming it trades while being compliant with all regulations is important. If it’s made its profits while cutting corners there could be repercussions for the next owner. Similarly, it helps to know of pending regulation changes in the industry since they might affect a business’s future profitability. Of course, BEE status of- and pending court cases against a business should come into the risk analysis before investing as well. Though it’s a long shot and shouldn’t effect businesses unless they are sole proprietorship, there are also risks involved in current or pending legal action against other stakeholders in the business (in their personal capacity). Even if the businesses assets cannot be touched directly, getting “into bed” with someone who’s soon-to-be cash strapped or have a serious dent in their reputation, might pose extra risks the business might not be able to carry.
The last two entries on the Business Information page are the Estimate of Business Value and what the estimate is based on. As mentioned in the previous blog this is always a bit of a delicate subject and there’s no right or wrong way to evaluate a business. This information will however, tell you a lot about how the current owner feels about their business and what their level of business skill is. A reasonable starting point for a price is usually the value of assets minus the liabilities plus a reasonable amount to compensate for any free cash the business is generating or potential the business might be forecasting. Alternatively, it might be based on previous offers escalated at relatively high interest rates (to compensate for the risk of being in business). It should always be remembered though that buying a business for cash isn’t the only way of concluding a transaction (though there is generally a cash component). For more information, check out my blog on "Business Valuation: A "How to” guide".
In the next blog I’m going to consider the SWOT analysis and how much to read into it.
This is the third in a series of blogs on the information required for a thorough due diligence before going into a substantial business deal. Today I’ll have a look at the SWOT Analysis.
SWOT is an acronym for Strengths, Weaknesses, Opportunities and Threats and it is a technique for investigating the internal and external factors that might affect a business currently and what one might focus on in the future. According to Wikipedia it is credited to Albert Humphrey.
Though this information is generally “high level” (and thus more likely to be shared early during a negotiation) it should be remembered that often there is a fair bit of formal and informal analysis behind it. When describing their companies’ Strengths, business owners may tend to romanticise their businesses exploits while they might downplay or even ignore their Weaknesses. Often having blinkers or rose-coloured glasses on are the biggest weaknesses. Business owners tend to have a feel for their business and how it’s going and this should shine through when doing a SWOT analysis.
It’s important to understand the context in which the SWOT analysis was done. If a business owner is in the process of selling the business or looking for investors, the Strengths and Opportunities will be put in the spotlight. If the SWOT analysis is done to analyse a running business it is more likely to focus on Weaknesses and Threats (i.e. where the business can be improved).
In the next blog I’ll consider what that can be read out of the Human Resource information for a business.
In this blog, the fourth in a series on the information required for a thorough due diligence for substantial business deals, I’ll consider Human Resource Information.
Regardless of the kind of business in question, somewhere in its structure there will be a critical reliance on the people who work in it. Some businesses are more automated than others but there is always still a need for human interaction and this interaction can define the image the business portrays. When a business changes ownership or gets a new partner, there will be inevitable changes in the way the business is run and in the way it viewed but the workforce that remains is just as important in guiding the businesses course. That’s why the Human Resource Information requires a thorough analysis as part of a due diligence.
On the BusinessPortal range of websites, there is space to define the role of all employees, managers, partners and/or board members (depending on the businesses size and requirements). It also shows their income and other benefits; information that is critical for the calculation of some of the costs in the business. The ratio of Human Resource costs to other cost in a business are generally fairly industry specific and could be an indication of being under- or overstaffed. Educational background gives an indication of the skill levels of each individual (though it is by no means the only indication that should be considered) and, when compared to the cost to company of these individuals, can give an indication their value to the company. Other interesting information is the length of time that people have been at a company. If the average for this is relatively low it might suggest a high staff turnover though this should always be compared to industry expectations. If it is relatively high it might suggest that people are generally happy to work there or that there are limited employment options in the industry. Similarly, information about employees’ union affiliations might suggest what new owners might be in for some salary increase negotiations.
Unfortunately the numbers are unlikely to tell the whole story for any individual in a company structure and it is hard to predict what a change in the ownership structure might prompt people to do. The reliance of a business on its Human Resources should not be underestimated and keeping people happy and productive requires much more than a set of numbers. However, this is part of the challenge of running a business and Human Resources is often a bottleneck in a business were value can be unleashed.
The Ownership Structure of a business follows on from the Human Resource Information and it determines the size of the challenge in negotiating a deal in obtaining some or all of the shares in a company or settling on a return on investment in a company. For more information on business negotiation, check out my blog on "Business Negotiation".
For most small businesses the Ownership Structure may be inherently simple. A single owner holds all the shares and has all the voting power. As soon as there are several partners involved, negotiations may get more complex because there are more powers at play. At the other end of the spectrum, if there is a large chunk of the company in public ownership, negotiations to get a (significantly smaller share) are somewhat easier again. You merely have to make an offer on the stock exchange the company is listed on. If that offer is good enough and a seller sees value in it the deal gets done. Off course this also makes the valuation of the shares much easier than in small and/or unlisted companies. For more information, check out my blog on "Business Valuation: A "How to” guide".
If parts of the business are owned by multiple parties, businesses negotiations will probably become as complex as they can get. Teams of people will try to thrash out a mutually beneficial deal on behalf of many peoples’ interests and this will cost time and significant professional service fees.
It’s well worth noting that the ownership structure doesn’t necessarily determine the way decisions get made in a company. In large companies a board of directors which might not hold a significant stake (in relation to the whole pie) are at the helm. Even in smaller partnerships, there is likely to be a core of partners (or a single one) that has its hands on the reigns. When buying into or investing in these companies one needs to be sure of the role you’re about to take on and the power you might be buying there to avoid future tension.
We now start getting to the nitty-gritty of how a business makes its money. The Selling Proposition refers to the products or services that a company supplies. Of course this information would be relatively self-evident at the point when one is negotiating for a stake in the business but sometimes there are income (and expense) streams to a business that add significantly to the bottom line but don’t form part of the core business that the company is known for. An example would be an engineering company that owns patents it sells the rights to.
At this level, it is important to ascertain costs that go into producing a product or service and the price at which that offering gets sold. The difference between these two figures is generally called a markup and it’s usually quoted as a percentage. Note that some products or services are complimentary and that the business might have to offer them, no matter what the cost, to help sales of other (hopefully profitable) products. A classic example is offering cheap razors to boost sales of expensive razor blades.
The BusinessPortal range of websites also include a few extra tidbits of information about the products or services that give a better idea of how they are marketed or positioned in relation to competitive products/services. Some of the comparative figures can give an idea of how to tweak the product/service to derive more revenue from it though it should be noted that the data given here is generally based on the sellers’ impression rather than a quantifiable metric. Also note that Marketing Spend often isn't specific to a product or service but rather aimed at uplifting the whole brand. It does however start looking into the costs of selling a product or service; a topic I’ll broaden in the next blog on Business Processes.
This section on Business Processes essentially drills down into the costs of production and cost of generating sales for separate products/services. It follows on from the Selling Proposition and essentially fleshes out products and services added in this section of the BusinessPortal range of websites (i.e. an investigation of the Operations of a business).
Before defining the split in product- and service production costs, the production processes for products need to be defined a little further. The BusinessPortal range of websites give the option to indicate that a product is bought in as a complete product, as part-product which requires assembly or as raw materials which need to be fashioned into the product from “first principles”. Note that the product may be a part product that gets sold on to other companies to be assembled. This depends on what the company being analysed sells on to its clients and should be read in conjunction with Supplier- and Client Types discussed in the second blog post in this series on the extended Business Information on the BusinessPortal range of websites. Payment- and Delivery terms for the parts that go into the products start alluding to the relationship that the company has with its suppliers and the planning that goes into ensuring that the production runs smoothly and does not run into issues of over- and undersupply of parts required for production (and the associated storage- and administrative costs).
The split in product- and service production costs give an indication which fields the costs of production go towards. Since we know the costs of production from the Selling Propositions section the cost per product or service towards each field can be calculated. The total costs in each field can be calculated once the total sales for each product/service are explored, which will happen in the Invoicing section (to be discussed somewhat later in this series of blog posts). For products the BusinessPortal range of websites consider the main fields of Purchasing, Labour, Transport, Services and Storage of Raw Materials and of Final Products. Considered fields for Services are Labour, Licence Fees, Services and Consumables. These sections should adequately describe the focus and efficiency of production of products and services and might indicate where the company is over- or underspending in relation to other companies in similar industries. This might show where a company is efficient in production of products/services (and has something by the way of expertise to offer) or where exploiting efficiencies might yield operational improvements.
There’s a cost for selling products/services. This often comes in the form of commissions paid on sales or salaries towards sales consultants. The salaries have already have been considered in the Human Resource section of the due diligence but Commissions are considered in the Sales section of the Business Processes. This section also shows the payment terms and delivery terms given to customers. If payment terms are extended to customers, an important metric to consider is the Income Recovery Rate, This will be considered in the Financial Information section on the BusinessPortal range of websites (see "Due Diligence" information - What do I need to know: Part 10 - Financial Information).
No Due Diligence would be complete without a thorough investigation of the assets a business has acquired. The BusinessPortal range of websites do this in the Assets section and you’ll find that it considers factors that the statement of assets in financials doesn't. That’s because the value of assets in “real life” isn't always the same as the value of assets as represented by accounting standards. In accounting, assets are depreciated by a formula that suggests they’d lose all their value in a specified amount of time (Property isn't depreciated, buildings generally over 20 years, furniture over 5 years, electronics over 3 years etc.). In the “real world”, assets are worth what someone would pay for them today (rather than what was paid for them when they were first acquired). When buying into a business, it is important to investigate both of these asset evaluations. The “real world” price is likely to be worked into the value of a business fairly directly while the current accounting value of assets bought has import on the (accounting) equity value of the company. The value of financial statements and their importance in a due diligence will be investigated in the last blog post in this series. Also see, "What you really want to know when investing in- or buying a business".
From a management account point of view there are 2 types of assets; Income generating- and non-income generating-. Income generating assets are the ones that are required for production (such as Raw Materials and Equipment), Stock on hand (since it can be sold for income) or assets that earn rent (Property), dividends/profits (Business Interests) or interest (Loans Given or Negative Balance in Loan Account). Non-income generating assets are things like Properties that aren't rented out (say the company owns the land it’s on) or other assets the company has bought (or pays for) that are not directly required for the production of their product/service.
There are several important things to note about the assets of a company one is considering investing in (beyond the value of assets). Some examples of these are:
To make money a company needs to spend money. And if that money is borrowed, it generally needs to be repaid with interest. If a business does not have any debt, it’s an indication that it’s not maximising on the opportunity of access to credit, which could be used to grow the business or maximise profits. If a business has too much debt, it might be struggling to repay the interest. The level of appropriate debt depends on the type of business and the returns it can generate from its capital outlay as well as the amount of trust lending institutions would put in it. The BusinessPortal range of websites consider these and other financial outflows in the Liabilities section.
The first section gives an indication on Outstanding Invoices gives an idea of the amount of money that the company generally spends in a month as well as how “up to date” the payments are. Given the time specific nature of Liabilities, they are all furbished with time stamps on the BusinessPortal range of websites. Though no one likes admitting it, some invoices are invariably paid late and this might incur future penalties. When investing in a company these might be nasty and unexpected little surprises. Though the BusinessPortal range of websites don’t go into depth at this point, it should be noted that some creditors are more lenient than others. Owing money to the relevant Inland Revenue Service is greatly more serious than owing money to a partner that is invested in the company since the revenue service can impose huge penalties and shut the company down. Incidentally, the BusinessPortal range of websites do not deal with tax liabilities directly, since proof of tax (and especially VAT or GST for relevant countries) payments are an important part of the paperwork that needs to be verified for a due diligence. The BusinessPortal range of websites give the opportunity to pass this sort of information on in the “Documents” section which allows for doc, docx, pdf, xls and xlsx files up to 5MB to be transferred.
The remaining sections are fairly self-explanatory and essentially represent sectors where money would normally flow out of the business i.e. repayments on assets, loans to internal sources (board members, partners, managers or employees), loans to external sources and overdue salaries (another topic that businesses don’t like to admit to but under tough economic conditions this might form a legitimate way of transferring costs into better months). Unsellable Stock reflects money that the business paid out (for raw materials, manufacturing costs etc.) that it cannot recoup. Depending on the nature of this stock, it may have to be written off (or donated) entirely or might need to be repurposed, reworked or sold at a loss. These sections are generally seen as Non-Current Liabilities in company financials.
The “Other Monthly Costs” section is essentially a “catch-all” for any costs that aren’t represented in the previous sections and is intended for recurring costs like rental. Note that Business Process related costs such as Purchasing of products or -raw materials, Labour-, Transport-, Storage- and Licence Fees, Services, Consumables, Marketing and Commissions have already been considered in the Human Resource Information, Selling Proposition and Business Processes tabs (See "Due Diligence" information - What do I need to know. Part 4 - Human Resources, "Due Diligence" information - What do I need to know. Part 6 - Selling Proposition and "Due Diligence" information - What do I need to know. Part 7 - Business Processes and Operations).
The last bit of formalised information that can be added into the BusinessPortal range of websites and that is critical to address during a due diligence relates to Financial Information and Invoicing. This information is obviously highly sensitive and is likely to be considered well into the discussion and negotiation between parties. This level of information will require that a trusting relationship has been firmly established.
When considering Financial information there are several important aspects. How much money does the company have currently and how certain are cash inflows? How much access to credit does it have and how has that credit been dealt with historically? How much money has the company generated historically and how much money might it generate in the future? To this end the BusinessPortal range of websites allow data on the current state (at data entry which gets tagged in the BusinessPortal range of websites) of bank accounts to be entered and swapped between negotiating parties. This information relates to account types, interest rates on positive- and negative balances, balance and credit facilities. It also gives an indication of current (at data entry) outstanding invoices and income recovery rates which is a telling indicator of income security (especially in the face of late- or non-paying clients).
Invoicing data is split into historical and forecast data which space for monthly data for the last and next year and annual data for the preceding and following 4 years. It is also split up per product or service. This information will tell the reader which products/services are the biggest money spinners (and thus which the business is most dependent on) as well as whether invoicing is seasonal.
This is the last blog post in this series on the information required for a thorough due diligence and it will consider how all the information mentioned in the series comes together to form a picture of the state of the business.
As with most things in life, running a business effectively is all about finding the right balance of where to put energy (and finances). Unfortunately this does not guarantee success since that also requires a viable business model and market but not striking the right balance guarantees that the business will not be as profitable as it can be or even a decline into bankruptcy.
At its core, the most fundamental business information is a comparison between the money the business makes and the money it spends and all this information can be gleaned from the information sheets on the BusinessPortal range of websites. Then one can drill down into the separate costs (for Human Resources, Business Processes (operations), Sales, Marketing, financial costs due to Assets and Liabilities, research and development, tax costs) and incomes (Invoicing for separate Products and Services) to determine where the company might be improved. Note that the BusinessPortal range of websites do not specifically consider tax costs and that I’d suggest using costs and invoices excluding VAT/GST to get the most accurate picture of the business. Checking that tax and VAT/GST returns (in the relevant countries) are up to date, submitted and paid is absolutely critical to a due diligence though. After all, one buys into a business with all its promise and baggage.
Financial Statements attempt to provide similar information about the running of a business and generally they will give a good idea of the overall state of the business. They do, however, have some significant limitations. They provide a snapshot at a point in time (the financial year end of the business) and thus, don’t give much of an indication how the business got there. When several years of financials are analysed this gives a better idea but it should still be remembered that accounting standards force them into a format that might not adequately represent all facets of the business and that businesses tend to “have their house in order” at their financial year end to avoid unnecessary tax implications. Having a complete and audited set of financial statements does indicate that the administrative side of the business is well organised though.
There are other, less tangible or -quantifiable things to consider when buying into a business. Examples are the company’s ethos, -customer relationships, the strength of its brand, its dependence on key people in- and outside its structure, its corporate social responsibility, the strength of alliances with suppliers and -clients, the strength of competitors, industry conditions and standards, economic conditions etc. Though a SWOT analysis may have hinted at some of these issues, there is no way of pinning down the impact of these (and indeed of an ownership change) on the business.
Doing a due diligence also requires a balance. Though all the information mentioned in the posts preceding this one should be available to all businesses, the size and selling price of the business may not justify the amount of time spent to dig it all up and analyse it. The BusinessPortal range of websites were set up to encompass the vast majority of the information required for a thorough due diligence but it should also be noted that this information cannot be verified by the website. It is thus up to the negotiating parties to determine the amount of effort that needs to go into the due diligence. As with most negotiations, there will always need to be some level of trust. For more information on business negotiation, check out my blog on "Business Negotiation".
There is no absolute bare minimum requirement for a due diligence and businesses have been sold on trust in the people involved and in the brand in the past. This approach is rare nowadays however, and generally only happens in businesses that are being sold to a friend, family member or long standing employee or manager. Generally, there will be extensive negotiations based on available information or assumptions and this offers a multitude of opportunities for deals to fall through.
All of the preceding blog posts considered the information requirements on a business during a due diligence. Most of this information is highly sensitive and will thus not be given lightly. Since a trust relationship needs to be built between negotiating parties there will be information requirements on the buyer/investor as well. Generally this will start with a Non-Disclosure Agreement that gives identification details and ties the parties into confidentiality regarding the deal and any information that may be required for it. Then there will need to be some way of assuring that the necessary funding is available (proof of bank balance and income, credit checks, pre-approved loans, assets that can be used as collateral for loans as well as liabilities etc.). It should be noted that often a portion of the funding can be paid over time and can be generated by the businesses trading activity under new ownership though this will depend on the eventual structure of the business deal.
Business deals on this level (selling a business, finding a new partner, looking for investors and looking for mergers) are a daunting prospect. From advertising to find an appropriate investor to going through the negotiation and due diligence to money swapping hands and contracts being set up and signed there are many pitfalls and unknowns that need to be overcome. For more information on the business selling and buying process, check out my blog "Interactive Infographic: The Process of Selling/Buying a Business". Subsequently there is no shortage of service providers that offer to help through some of these processes (brokers, accountants, lawyers etc.). The BusinessPortal range of websites have endeavoured to provide a structure to help with finding investors, guiding the negotiation and simplifying the due diligence for the vast majority of businesses out there (irrespective of size and industry). Though we don’t expect a deal will ever be made without face-to-face meetings, meaningful personal- and business relationships are being built online and the structure provided can educate and inspire buyers and sellers in this complex market. For more information on how BusinessPortal-GLOBAL endeavours to do this please check out the explanatory YouTube clip below sourced from the parent website at www.businessportal-global.com (Similar to the clip linked to in the footer of the BusinessPortal range of websites).
For the last 100 years or so, the gold standard in the measurement of human intelligence was the standardised IQ (Intelligence Quotient) test. Though the tests have changed over the years, they are essentially a measure of analytical ability and logical thinking. Then, in the mid 1980’s the concept of emotional intelligence, referring to a person’s capacity to intuit one’s own- and other people’s emotions, started creeping into scientific literature. Businesses are a lot less complex than human beings, but I’d like to think that they also require the right balance of these “intelligences” to be successful.
The language of business is economics. At an individual business (or industry) scale microeconomic concepts like “demand and supply” and the “law of diminishing returns” hold sway. At larger scales of countries’ economies and governmental functions, macroeconomic principles like monetary- or fiscal policy start adding factors. But economics is a “social science”. This means that, while accurate measurements can be made, the deductions made from those measurements often include a fair bit of gut feel, guesswork and assumption built up on previous empirical experience. (Apologies to any economists out there who are offended by this generalisation).
Over the next few blogs, I’ll consider the “IQ” and “EQ” components of some of the major functions of any business. I’m hoping that some people will learn the importance of gathering some information and that others might learn how to read into information once it is gathered.
At its core, there are only two factors that determine the success of failure of a business. Its income and its expenses. If the income is higher than the expenses, the business will (at very least) survive. If the expenses are perpetually higher than the incomes, it will ultimately fail. The longer funds are borrowed to cover the shortfall, the more spectacular the failure can be so beware!
This brings us to the first fundamental EQ question. Will this business eventually make more money than it consumes and will it be enough and early enough, to make it worthwhile? Of course, financial analyses can help with this question, but these forecasts are based on assumptions and are thus never accurate.
Incomes are generally easy to ascertain. Just look at the invoices going out. They will tell the story of the amount of sales of each product or service, the seasonality of the business and the relative size of projects or the value of each sale (i.e. few sales of a high value item or many low value item sales). Income recovery rates will factor into the actual cash flow of the company which may be a concern if it is highly seasonal. However, unless some of the invoices are not paid or the interest rate for bridging finance is excessive, ongoing businesses should not have problem as long as average incomes are higher than average expenses. Other incomes include interest and dividends a business might get from investments (in a bank, market or other businesses). These may be higher than invoiced services or products, depending on the type of business.
The expenses are somewhat more complicated. They are generally split into fixed- and variable expenses. Fixed expenses recur regardless of the amount of production and sales. Variable expenses increase linearly (i.e. in proportion to the increase/decrease) as the production (and hopefully sales) changes. Examples of fixed expenses are salaries to management and administration and payment for fixed assets though it should be noted that even these need to vary if production increases or decreases drastically. Variable expenses go towards things like raw materials, storage- and transport costs, services, salaries to employees and consumables.
At this point it is worth noting that a mark-up on a product or service often doesn’t include all of the fixed costs. Thus, the margins often sound much more generous than they are. This depends on the ratio of fixed and variable costs and how much of the margin needs to go towards covering fixed costs.
You will already have noted that simply sticking to the numbers, even on this, the most basic level in a business, could require a fair amount of complication. That said, very few business owners have their finger on the IQ pulse enough to be able to work of these numbers. Instead, they’ll worry about the size of margin on products and services and how much they need to sell based on gut instinct and years of experience. They’ll let the accountants give them the final numbers at the end of the financial year. If you are evaluating a business and don’t have the experience in that industry, reverting back to crunching the numbers may be your only option… if you can get hold of the raw data.
Before a business can make a dime, it needs to have something to sell. This may be a product or a service determined by what the company charges for. Products are generally charged by adding a mark-up on the cost of production or acquisition. Services are generally charged per hour that’s gone into producing the service.
If a company sells a product that is either bought-in or needs to be partly- or fully assembled or -manufactured, the operations function generally needs to follow an IQ set of criteria. It will consider aspects such as production capacity and timing, supply of raw materials, maintenance to the production line etc. There is very little scope for EQ short of the management and motivation of Human Resources (which I’ll consider in the next blog). This is thus generally a very easy part of the business to analyse. One merely need to ensure that production matches supply (or at least doesn’t outstrip it vastly) and find bottlenecks that can potentially be alleviated to make improvements.
In the case of service companies, these processes may be a little harder because the main producing assets have a will of their own. People can only be pushed so far or motivated so much before they run into the limits of their capabilities or will to produce. To increase their production beyond that point one needs to encourage training and education and the returns on this investment of time (and money) are generally not linear (or even directly measureable). They thus require much more “gut feel”, relationship building and coaching.
The Marketing and Sales functions of a business (excluding the operational side of collecting money and delivering a product/service to the customer) are largely EQ based. Though there are “tricks of the trade” that can be learnt, generally the difference between a good salesperson and a bad one comes down to the people and how good they are at interacting with clients. Similarly, marketing campaigns need to form an emotional connection with potential clients to be effective. Thus, improving the sales and marketing functions of a business can be quite tricky. One cannot just throw money at the problem and expect a predictable and linear return on investment.
By now it should become apparent, that the EQ requirements of a business come about because of its need for people. Businesses rely on people for employees, management, investors and clients and the next blog will consider the Human Resource function.
For the purposes of this blog I’ll expand “human resources” to include all interactions between people in a business: I.e. interactions between owners, investors, board members, managers, employees, service providers and clients. Unlike other “assets” to a company, people generally have a much broader scope and character than what the company requires from them. From the companies point of view, they are required to perform their functions, preferably at a cost lower than their cost to company (though their value to the business is often hard to define – e.g. the marketing and admin departments – crucial but difficult to quantify) and without disruption to other functions.
People do, however, generally have broader motivations than just their interaction with the company. They put importance on their social- and family life outside the company, hobbies, other endeavours etc. and as such, they have motivators competing with the company’s efforts. Note that some of those motivators may come from competing companies. Of course, there’s nothing business owners and managers can do about this. Some (those who don’t believe in pure altruism) even say that peoples interactions are solely determined by their own self-interest so their performance is determined by the perceived “good” they (or their immediate family) will derive from it.
Finding the appropriate managers/employees/investors/partners/clients requires that their interests and those of the business are aligned adequately to produce a positive interaction. Since peoples motivational interests are generally difficult to define or very broad (e.g. salary, working hours, working conditions, skill level, education, experience, product requirements, emotional connections to the brand/product/company, etc.) one needs to inject a healthy dose of EQ to determine if that person should be hired or courted as a customer. The adage seems to be “hire for attitude” and attitude compatibility can only really be defined by gut feel.
Of course there are some character- and personal qualities that can be defined or can be gleaned from definable attributes. As an example, level of education and experience is an indicator of the level of motivation to better oneself or stick at a job as well as an indicator of skill and intelligence. This is generally produces the “first draft” list of candidates for a position but this “IQ” definition of achievement almost certainly skips over suitable candidates who may not fit into the traditional definition of “educated” or “experienced”. Either way, one will never be quite sure how well a person might fit into- or change an established team or company culture.
So how does one go about designing the interactions required to run a business as smoothly as possible? Initially, by trial and error. This is often one of the stumbling blocks of fledgling businesses. At the time when it requires as much certainty and controllability as possible, it needs to deal with the relationship issues that come from a poorly defined company culture and desperate scramble to figure out the market and make ends meet. Once it has sussed out some of these aspects, it can start to build-, manage- and rely on a reputation and culture, to attract the right people and customers. And by that time, it’ll have plenty of experience in what works and what doesn’t work to draw on.
Businesses grow. They generally start out as simple ideas. They are then mixed with energy, optimism, a little funding and a lot of scrambling to make the idea feasible or to conform it to the needs of the market enough to produce a consistent income. As they grow and change, experience about what works and what doesn’t is gained by those involved in shaping the businesses. They also make assumptions as to the reasons for successes and failures but generally, very little of this gets documented for posterity. At best there will be financials (and the paperwork that goes into producing them), a few evolving policy documents and ad campaigns, and some bills for costly mistakes (school-of-hard-knocks fees) to remind business owners what they’ve been through and what they’ve learnt along the way. A lot of the factors that will influence a business’s success or failure might not even be recordable. How would one write up the character traits of key employees or managers or the flow that a team can create?
As businesses grow larger, some of the systems that make them function well become ingrained. They form part of the company culture and the “way things were always done” (though, if this is too rigid it may cause problems down the line). If the business is big enough to have separate managerial functions, it will tend to start documenting results by way of minutes of meetings, managerial reports and management accounts. These form an invaluable source of data and could be analysed to glean some of the institutional information that makes a company tick. Smaller (and family) businesses tend to keep going for years based on the experience and gut-feel of individuals in the management structure. Note that this way of running a business seems to be no less successful than running it based on the hard numbers analysed in minutia and both can mitigate and cause their fair share of stresses (fear of the unknown or fear of the known respectively). It will, however, cause problems when the time comes to pass the business on to someone else.
Unless they worked in the companies structure, when a new person takes over (for whatever reason), they will struggle with the nuances required to keep operations smooth. They are generally motivated to make sweeping changes and improvements anyway (why else take over a business). For this reason a “hand-over” time, where the previous owner shows the new owner the ropes, is often stipulated in a business sales agreement.
In the end, the business owner needs to be comfortable with the level of information that they produce and analyse to run a business. For some, this may be full management accounts and psychometric profiles. For others this may be come down to the firmness of a handshake and a good feeling about their decisions. Both approaches have their advantages and disadvantages and both can lead to success and failure. Most business owners and managers will fall somewhere on the spectrum between those two extremes. As long as they know that, at some stage in the life cycle of the business, someone will want to see the nitty-gritty numbers.
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The time has come to sell your business. This is a rather daunting undertaking with organisational-, financial-, legal- and social hurdles to overcome and it makes sense to look for help. Your first option might be an internet search on how to sell a business and you’re immediately bombarded with business brokers who claim to be able to sell it quickly and at the highest value. They have professional looking websites and promise lists of qualified buyers looking for businesses just like yours. But then you dig a little deeper and you start finding stories about business sellers who have been ripped off by unscrupulous business brokers who didn’t do much for the exorbitant commission they demanded. I’m hoping that this blog can help you to decide whether you need a business broker, and what they should be offering you if you decide to list with one.
As a business owner you’ll know that your decision on the use of a business broker should be based on sound financial reasoning. This means that hiring one should be based on at least one of these reasons:
If neither of these conditions is met, they are making money at your expense. Unfortunately, it’s extremely hard to quantify the value they might add to your business (since you’ll never have a comparative offer) so I’ll focus on the functions they may help with and what the services they offer which should add value.
However, before I start with the services business brokers offer, it’s worth considering the business brokers’ business model.
It might be stating the obvious, but business brokers are in business to make money. This means that their efforts will naturally gravitate towards the markets where they can make the most profit for the amount of time they are willing to put in. For some business brokers this means focussing on a particular area and/or industry or specialising in businesses of a particular size. For others this might mean putting a smaller amount of effort into many more businesses to cast a wider net. Needless to say, more personal attention should be the order of the day from the business seller’s point of view. Increased marketability of a business, and thus increased opportunity to earn a commission, will determine the amount of effort a business broker will put into selling a business (or whether they will list it under their name). Thus, businesses offered by business brokers generally seem to be profitable, well run and established. Very few business brokers will help you to sell a business that is struggling or a fledgling. These businesses are more likely to be served by business incubators.
There are generally two ways in which business brokers charge. They can charge a commission on the sale of a business or they can charge a service fee based on the number of hours they have put into a particular function (such as valuing the business or creating a marketing brochure). The way they structure their billing should immediately indicate the level of service one might expect from them. If they want a large, upfront payment for services and no commission, they may be tempted to tail their service off once the billable work is done. If they charge only a commission, they may be tempted to advertise with little or no business preparation. A fixed commission might tempt them to try to sell more businesses at a lower price. The best compromise is generally a payment for upfront services followed by a “selling price” dependent (sliding scale) commission, sometimes with the upfront payment deferred or taken out of the commission on sale. Note that commissions seem to be anything between 3% and 15% depending on the size of the company, country and level of service offered by the broker. This should suggest that commissions can be negotiated between seller and broker.
Note that, in most countries, to charge a commission on the sale of businesses and the property tied up in them, business brokers need to be registered estate agents and that this is generally the only qualification they need. Due to this relatively low barrier to entry, there is very real scope for unscrupulous- or incompetent business brokers and in difficult current market conditions there has been grumbling about estate agents moving in on business brokers’ turf without the proper knowledge required to sell businesses. To mitigate this, there are regional and worldwide business brokers associations and it is certainly worth investigating if a potential broker is a member.
In the next blog I will consider the functions business brokers perform in the process of selling a business.
The previous blog had a look at the business brokers’ business model. This blog will consider the services they actually offer. These services can be grouped under several headings:
There is no one “correct” way to establish a value for a business. The most accurate measure of a business’s value is the price at which a willing seller will sell to a willing buyer. For businesses that are listed, a value of a business can be ascertained because there are likely to be at least a few trades of a business’s shares on a regular basis (since there is a willing buyer and seller for a share in the business). Though this won’t be the fixed price when buying a large chunk of a business (these are generally done at a premium to the individual share price), the market capitalisation of a listed business is generally a good starting point of its value.
For businesses that are not listed, there will much fewer share interactions so this is not a viable method of valuation. At this point, valuations are generally an estimate of current replacement value of assets held in the businesses as well as/or an estimate of the future value it can create through sale of its products/services or the strategic advantage it might offer. There may also be an element of comparison to asking prices for similar businesses which are currently for sale.
Since valuation is partially subjective, enhancing that value through changes in a company (structure, product, service, operations, marketing, etc.) can have variable results though increasing profits is generally a good sign. Very committed business brokers, as part of their service, work with business owners to ensure that a business presents as well as possible when it comes to selling it. This may be a relatively long-term (18 months to 2 years prior to listing) commitment of business coaching and/or management consulting. For more information on business valuation, check out my blog on "Business Valuation: A "How to” guide".
Most business brokers will offer a valuation service (either themselves or by affiliated specialist valuation companies). Note that business brokers walk a fine line between presenting business owners with a price that is high enough for their expectations for their business (which are often inflated due to years of blood, sweat and tears) and low enough to be market related and give the business a good chance to sell. Either way, the valuation is just a starting point for negotiations and buyers are going to present valuations to substantiate their point of view of the company (which are always going to be lower than or equal to the asking price). The negotiations will determine at what price (between the asking price and buyers valuation) the business will eventually sell if the sale goes through.
Note that, before a business can sell, its financials generally have to be in order and it needs to be in good standing with the taxman. Some business brokers will help with this though most generally represent businesses that aren’t likely to have these hurdles to overcome.
To market a business to potential buyers, business brokers generally set up a marketing presentation. This presentation usually contains some general business information, a SWOT analysis and a reason to sell. It may also be quite a bit more comprehensive covering human resources, ownership structure, services and products, operations, assets and liabilities and more detailed financial information (essentially information gathering for due-diligence). To set up this presentation, business brokers will need to spend varying amounts of time (depending on the comprehensiveness of the presentation) in the business and with its financials. This presentation is shared with potential buyers (usually after a non-disclosure agreement is signed) but control over who gets to see this sensitive information should be at the forefront of the business brokers (and business owners) intentions. Vetting of potential buyers will be considered under the next heading.
Business brokers will have you believe that marketing a business for sale to the general public is fraught with danger. For bigger transactions, businesses are generally marketed directly to potential buyers or institutional investors. If not marketed directly, businesses are generally marketed anonymously out of fear that knowledge of its “for sale” status might affect current trading. It is assumed that this happens due to changes in relationships between owners, managers, employees, clients and suppliers and that a competitor may attempt to find out more about the running of the business or to jeopardise the sale. One should consider as well that business brokering is a rather cutthroat business and that some of them attempt to “steal” mandates by approaching business owners directly. Thus business brokers have a vested interest in keeping the business anonymous (or signing a “sole-mandate” agreement with business owners).
There is an advantage to having multiple potential buyers because sellers can play them of against each other during a negotiation. The likelihood of attracting several buyers depends on the saleability of the business and the effectiveness of its marketing. Note that, depending on the compensation structure, business brokers may have more interest in finding single potential buyers rather than multiple buyers for each business. Once a viable buyer is identified they may feel that their time is better spent focussing on their other listings.
The amount of data released and under which conditions (e.g. initial marketing, “non-disclosure” agreements in place or “letter of intent”) forms part of the dance during the negotiation process.
Before a negotiation can get under way, business brokers often vet buyers, ostensibly for their financial status and fit as owners of the business. Buying a business often requires a substantial financial investment (depending on the business deal the current business owner might be interested in). Note that it is in both the business owners’ and business brokers’ best interest to find buyers who are most likely to complete the sale process and that a large section of responders to marketing attempts are likely to be “tire kickers”. Doing credit checks can be fairly routine nowadays though it generally requires consent. Business brokers who claim to have “hundreds of qualified buyers looking for businesses just like yours” often neglect to mention that these buyers are qualified only because they have subscribed to the brokers website or mailing list. This is a marketing ploy by some business brokers to attract new listings. If they had serious buyers their time would be better spent looking for businesses than waiting for them.
Negotiation is a fine art. It’s an interaction between two or more parties who have different expectations and agendas and it involves information (and its interpretation) and sometimes emotion. The hope is that a mutual agreement, that all parties can live with, can be reached but by negotiators natures, it can be quite adversarial. Business brokers can either represent or advise the buyer or the seller during the negotiation. They often see themselves as a buffer between the buyer and seller in the hope of taking out some of the emotion that these parties might have invested in the company or the sales process. It should be noted though that they will never know the business as well as the business owner and that their interest will always slant towards the completion of the agreement first (so that they can get paid) and secondly towards the party who will eventually pay them. Often both buyers and sellers have business brokers to represent- or advise them during the negotiation. The value of a good negotiator cannot be underestimated but, once emotion is mitigated as a factor, the business information should be the guiding factor to reach an agreement. For information on the sort of information required please see my blogs on “Business Information” and “Due Diligence Information”. For more information on business negotiation, check out my blog on "Business Negotiation".
By virtue of dealing with many business sales, business brokers will have a good idea of all the administrative-, financial- and legal processes required as well as the local regulations that may pose stumbling blocks. They also have a vested interest in making sure that the process doesn’t stall or slow down since they generally only get paid once the deal is done. This means that they will keep up the pressure on both the buyer and the seller to complete the transaction. Given that the buyer and seller will generally have an interest in getting the deal expedited the business brokers’ knowledge and contacts might be useful.
A notable exception to the administrative services that the sellers’ business brokers generally offer seems to be help with the due diligence. This is the process where the buyer verifies the information that the negotiated agreement is based on. Business brokers usually cite a conflict of interest when it comes to this task and pass it on to (or suggest) accountants.
In the next blog I will consider when a business broker will add value to a business deal.
In the previous two blogs I discussed the business brokers’ business model and the services they generally offer. In this blog I will discuss when one should consider using their services.
As mentioned in the first blog in the series, they should add value to the transaction. I.e. they should save the business owner time, aggravation and/or money over the course of the business sale process.
The question then becomes how much of the business sales process the business owner is prepared to- or capable of tackling on their own. I will investigate the sales process step by step as per the "Interactive Infographic: Process of Selling/Buying a Business” blog.
Preparing a business for sale requires the finalisation of financials and any outstanding tax issues, collection of data one might require for the sale of a business (of which the financials are part) and getting the business in order so that it can command its highest price. To finalise the financials and deal with outstanding tax issues one will require accountants. To get the business in order should be an ongoing concern of any business owner. It should not just come up when the business is to be sold. If the business owner has an experimental nature, they will have tried to improve their bottom line constantly. If they are a little more settled or have been complacent about- or a little more distant (not being involved day-to-day) to the running of their business they may want to have a closer look at improving profits and cutting some of the dead weight in the business. Either way, myopia or “not seeing the woods for all the trees” may have set in and getting a second opinion on improvements that could be made could be invaluable. Suggestions could come from trusted advisors or business partners, management coaches or -consultants or very dedicated and highly trained or experienced business brokers that specialise in the businesses particular industry. Alternatively, the process of collecting the relevant data required for a business sale (see "What you really want to know when investing in- or buying a business") and improving the factors that go into a company valuation (see below) might highlight where the business should be focussing attention to increase sales or margins or where it could be reducing expenses or cutting dead wood.
Company valuation is a rather tricky field because there is no correct, definitive value to a business. The only moment the value of a company is set is at the moment of sale of some of its shares when a willing buyer and a willing seller agree. Company valuations are based on some or all of the following factors:
As such a valuation can become quite subjective. Business owners tend to believe that the value of their company is higher than it is because they price in the effort it cost them. Business buyers tend to believe that companies should be valued lower than the asking price because they need to price in uncertainty (and because they need this as a negotiating starting point). When business brokers are asked to get involved with valuations, they have to walk the line between offering the seller a price at which they will be happy and the buyer a price which is an enticing starting point for a negotiation. Unfortunately, businesses are not advertised with enough information to justify the valuation. The price thus just sets the price bracket the potential buyer is shopping in. Whether or not they will eventually see value in the business will only be ascertained during the negotiation and due diligence process. Business brokers can help by offering a valuation service (or recommending a valuation company) and by tempering the sellers’ expectations. They can however also convince the seller to drop their price in an effort to sell the business quickly to get their commission. The next blog considers business valuation more closely (See "Business Valuation: A "How to” guide").
Marketing presentations should tell enough of the story to entice potential buyers to have a closer look but not so much that it puts the business at risk. As such they tend to be released in a two-staged approach. Initially, very limited information such as asking price, profit or free cash flow, location and type of business is used as the marketing profile. Once a potential buyer has committed to a non-disclosure agreement, more sensitive and substantial information can be supplied. The sort of information that is required for the in-depth portion of a marketing presentation can be found in my blog series about “Due Diligence Information”.
Most business brokers will help to create the “limited information” presentation. The level of information for the “in-depth” presentation varies may be considered beyond their scope because they feel that it gets too close to the potential conflict of interest of helping with the due-diligence (see below).
The level and approach to advertising a business for sale depends on the size of the business and who it is being marketed to. At their simplest level, businesses are sold to current employees and/or managers who have learnt the ropes and paid their dues in-house. This generally happens in consulting businesses like accountants- and law offices (with people making partner) where continuity of the client relationship with people inside the company is important.
If the business is in a very specific industry that requires specialised skills and knowledge to run (e.g. engineering consultancies or medical services), it is likely to be marketed on a one-to-one basis to potential buyers within professional networks. Though business brokers are in the business of networking broadly, they often don’t have the connections in specialised fields required. Often, these businesses are more likely candidates for mergers or acquisitions than sales to new owners.
The less specialised the knowledge required to run a business and the smaller it is, the more likely it is to be broadly advertised to the general public. Examples of these kinds of businesses are restaurants and convenience stores. Advertising used to be done in classifieds but have quickly moved to internet based advertising pages. These businesses are generally marketed with as little information as possible and require more stringent vetting of potential buyers (due to their broader advertising spread). Business brokers generally act in this section of the market though they may decide to specialise in particular markets (such as restaurant and entertainment or manufacturing businesses) and business sizes within this segment. Business brokers will generally market listings on their own websites and social networks (Facebook, LinkedIn) as well as “business for sale” style websites (which individual business owners also have access to). They will also root out “tire kickers” who are interested in business information but do not have the means or knowhow to complete the sale.
To make sure that the business deal has the best chance of happening, one needs to make sure that one doesn’t waste ones efforts on potential buyers (or businesses) that do not have the means or knowhow (or desired level of profit or potential) that are prerequisite. This requires credit checks (and/or checking assurances about funding) as well as a small personal interaction (at least). Business brokers guard against “tire-kickers” and people trying to glean information about the business for reasons other than sales interest but peoples intentions are generally fairly clear and easy to ascertain. Credit checks require varying levels of permission (depending on country) but there are generally online solutions to getting these done easily.
Non-disclosure agreements attempt to secure the business sellers right to keep to business information out of public reach and (sometimes) to stop potential buyers from setting up competitive operations. They also generally act as the primary hurdle for business brokers to release more information towards potential buyers and thus protect the business broker from the seller should information leak (by giving the seller another party to hold liable). Generally non-disclosure agreements don’t seem to be a very effective way to legally stop information getting into the wrong hands since they are easily circumvented. They do, however, indicate a level of interest and intent from the buyer and will allow negotiations to be more open. Sample non-disclosure agreements can also easily be found online or obtained from lawyers. Most business brokers will insist on using their own non-disclosure agreement.
Negotiation is often referred to as an art and practiced negotiators often have an advantage at the negotiating table. Generally business owners get some experience at negotiating (with suppliers and clients) in the course of running their business but the stakes are somewhat higher when negotiating for the sale of the business. The outcomes of negotiations are generally affected by the amount and quality of information that gets shared and the emotional state of the negotiators. The more a party thinks with their heart rather than their head, the more likely they will be taken advantage of during a negotiation. Having an external party can mitigate the effect of emotions on the negotiation but increases the complexity in information flow (needing approval for what can and cannot be shared). At the end of the day, the information that the agreement is based on needs to be accurate and comprehensive. Should information that would affect the deal not be disclosed, it might form the basis for a breakdown of the deal (at best) or legal action. For more information on business negotiation, check out my blog on "Business Negotiation".
The letter of intent is a legally non-binding document detailing the buyers’ intent to make an offer on a business. It is usually given during or after negotiations and states the details of the business deal and that it is contingent on a successful due diligence which is bound by the confidentiality agreement. Business brokers generally have samples of these letters on file but they can also be easily found online or obtained from lawyers.
Business brokers who are hired by sellers generally don’t get involved with due diligence because there is a conflict of interest between the buyers’ and sellers’ intentions at this point. Buyers need to verify all the information that the negotiation and tentative agreement is based on before signing the final contract. Business brokers might be hired by buyers to aid in this process (especially if they already had them help out during the negotiation process) though accountants might be more suited for this role. Please check my blog series on “Due Diligence Information” for the sort of information that would be useful and easily verified.
Though legal agreements are available for download from the internet (which could be amended to fit the business deals particulars), both the buyer and seller of a business will want the peace of mind that comes with a lawyer having set up the paperwork. Business brokers will generally have a lawyer they can recommend. Some might have sample agreements on file (as case studies for different business deals) but most will be reluctant to take on the responsibility of having these amended and used without a lawyer.
So the question remains: Do you need a business broker? The answer is: It depends on the business you’re trying to sell, how fast you want to sell it and how much effort you are willing to put in yourself. None of the services offered by business brokers are so specialised that reasonably savvy and involved business owners could not learn to do them themselves in the time required to prepare and sell their business.
Some businesses are not suitable for sale with the help of business brokers. These are:
Business valuation is a rather inexact science. Some aspect of it may even be referred to as an art, requiring imagination and forethought. But, even though it is a partially subjective field, business is hugely reliant on it as a starting point for a negotiation when any stake of it is up for an ownership change (either for sale, internal change or as options). Since businesses and business deals range vastly in size, scope and complexity there are many different ways to calculate and justify values for businesses. In this blog I will consider the principles behind some of these calculations and when one might apply them. By definition, the value of a company is a price a willing buyer would be willing to pay to a willing seller for a company or share thereof. Since this price depends on the negotiated agreement between the buyer and seller it is a compromise between their respective views of the value a business has or can create. This means that the business may have different values to different buyers because of the influence they may have over its future potential. The smaller the influence a buyer has over a business’s potential (by virtue of the size of the stake they are buying or the decision making power they may have) and the more frequent a change of shares occurs, the more rigid and defined the price of the business. Generally, businesses are bought- or invested in because investors want access to potential future income via one of the following routes:
There are three general approaches to arriving at a value for a business. These are:
Asset based valuations set the value at the cumulative replacement value of the assets (excluding the amount still owed on them) the business requires for day to day running (at least) or those that are included in the sale. For most physical assets, finding a current replacement value is a relatively trivial exercise. Using depreciated values (from the company’s financials) would be extreme since accounting conventions generally allow assets to be written off much quicker than fair market value would, so adjustments need to be made when attempting to use this valuation from the financials (part of the process of “normalising” financials). To rely only on asset based valuations one would have to estimate the value of the intangible assets (such as brand or institutional knowledge) of a company. These are usually lumped into an “asset” value called “goodwill” and are largely subjective. A notable caveat to asset based valuations is that the buyer should have the right to sell the asset after the sale for the valuation to be meaningful. If they do not buy a controlling share this valuation may not be appropriate. Often, the current value of assets will be seen as the absolute minimum value a business should fetch.
Market based valuations rely on comparisons to the value of other businesses in the same market. Values are generally expressed as a “multiple” of sales or profit that is industry specific. This multiple is a factor that estimates (by means of averaging) market and business conditions and demand and supply (for businesses to be sold) in a particular industry. This immediately brings up the issues that no two businesses will ever be exactly comparable (perhaps excepting franchises) and that data for “multiples” needs to be extrapolated from available data. Getting multiples from listed companies is relatively easy (given their financials and stock price) but these generally need to be adjusted down for private companies due to the lack of liquidity (i.e. the demand for) in their shares. Data for private companies is also available from business brokers but this data is extrapolated from a small sample and is not reliably collected.
Income based valuations attempt to estimate the future income of a business. They then assume that the current value of the business is equal to an investment (at a specified level of risk) that would pay out a similar amount in the same time. That investment amount is the current value of the business. These methods require significant amounts of analysis of historical results and their associated market and business conditions. They then require assumptions of how the market will change in the future as well as the impact that this may have on a company. Other assumptions that have a major import on these analyses are:
Income based valuations are based on the most accurate models of the value a business can create (often calculated from normalised financials) but they inherently require many assumptions about the future and the level of risk for a company.
This leaves us with the question of when to apply which method of business valuation. Unfortunately there is no set answer for this. All evaluation methods have their merits and distractions and all give different answers to the ultimate value of a business. The valuation is thus dependent on the initiator of the valuation process. A business seller would want the highest possible value for their business. A business buyer would be aiming at the lowest possible value. Stock market investors look for a value that is higher than the current stock price while being justifiably representative of future movements. The valuation also depends on the amount and type of available information and the size and status of the company in question.
The most complex and large businesses are often the easiest to get a relatively accurate value for. If businesses are listed, the price of their shares multiplied by the number of shares in issue (the market capitalisation or MCAP) will determine the value of the company (at least the portion of it which is floated on the stock exchange). This estimate of a company’s value is a representation of the average values that many buyers (and investment funds) and sellers ascribe to it. Most funds will spend significant resources analysing companies based on their financial data and forecasts (many of which are useful for the valuation of smaller companies though probably too labour and information intensive). Other investors influence the share prices through the mass effects of their incremental beliefs of the value of the company (i.e. mass psychology). The end result is a value that generally only varies a little from day to day. Investors “bet” on the cumulative effects of these daily variations (day trading) or on perceived value, which they think the market will eventually recognise (value investing). When larger stakes are bought in listed businesses, pinning down a value becomes more challenging. The sale of a larger stake will allow the buyer more influence over the company (and its future value) and thus, the price will be negotiated. Rumours of sale of a listed company or larger part thereof will generally cause the share price to move towards the negotiated price as increased or decreased investor demand (generally depending on what the company is being bought for – expansion or liquidation) drives valuations and mass psychology. The valuation of listed companies is generally done via a combination of valuation methods, the emphasis on which one depending on the industry the company is in. Investment companies will value companies in industries that are relatively mature and highly competitive (where companies are not likely to change the way they earn a living and growth is generally determined by the growth of the market rather than innovation) by income based methods. In industries that are capital intensive (such as manufacturing or mining), asset based valuations might form the basis of an analysis with an income based portion based on assessments of future projects or contracts. They would generally use market based comparisons (e.g. Price/Earnings ratios) to compare companies and help to inform investment decisions only. Less sophisticated investors (individual investors – no offence intended) might use market based valuations like P/E- (Price/Earnings) or other ratio comparisons or (so-called) “technical” analysis (essentially betting with a stock prices movement momentum or other historical trends).
If the company which is up for sale is not listed there may be much less to go on as a starting point for a value. Previous share sales may not have happened or it may have been years prior to the current sales event and undoubtedly with the company at a different size and under different conditions. And even then, these previous sales may only be a tentative guideline and not representative of the value that a new buyer or investor might extract from a company. So where does one start? The first question that needs to be asked is: At what stage of the business life cycle is the business? These stages are generally Start-up, Growth, Maturity and Decline followed up by either Rebirth or Death. Businesses in each of these stages have different properties which lend themselves to some valuation analyses better than others.
Companies in this phase of the business life cycle generally have no historical financial data to analyse. These companies also generally don’t have much of an asset base to base a valuation on. At best, if they are going into a competitive market, they can be compared to similar companies but generally their evaluations are based on forecasts of the market, and assumptions about the business idea and the capabilities of the business team. Forecasts are generally conservative and impossible to quantify accurately. The assumptions are subjective, insecure and qualitative. Thus, investing in these businesses presents the highest level of risk which means that investors will demand high returns on their investment. Therefore the valuation of a business at this stage has less to do with the eventual value the business might create and more to do with the amount of money it may require in the near future (from the sellers side) and the risk appetite of the investor (from the buyer). As a consequence, the difference in value between a seller and a buyer is likely to be high.
In the growth phase the business concept of the company is proven and its focus is on expanding to fill the demand for its products. It will be in the process of increasing its asset base which might mean that it has taken on more debt. Asset based valuations would thus not be appropriate due to higher liabilities. Such companies will also be reinvesting any potential profits (or even make a loss) to finance the expansion. Thus some market based valuations (especially multiples of profits in relation to costs) would be disadvantageous. The only real option to value such companies is to use income based valuations. However, since the level and rate of growth is less predictable than in mature companies (see below) income based valuations for these companies rely on less predictable forecasts which exposes potential investors to higher risks but also higher potential profits than mature businesses (though not nearly as high as start-ups). The valuations of sellers and buyers are likely to be closer than for start-ups but not as close as for mature companies.
Mature companies rely on maintaining the status quo. The business model has been proven to work and they have carved out a market segment. The growth of the company is dictated by the organic growth of the market and gains in profitability can only be made by reducing costs. These companies are generally asset rich and a large proportion of the company value will be in the value of the assets. They will also have significant historical data that can be used to estimate future cash flows, costs and profits. Thus asset based valuations will determine the bulk of the value while income based valuations will become more consistent and predictable. Buyers of companies in this market segment are looking for a (virtually) risk free investment with predictable returns. They will thus pay a premium. Though valuations are becoming more predictable (also between sellers and buyers valuations), market based valuations are still dubious because of the data they will be based on. Comparative industry data for sales of privately held companies is unreliably collected and limited. It should be noted that most listed companies fall into this phase of the business life cycle.
By definition, companies in this part of the business life cycle are struggling and their valuation will depend on whether they will be followed by rebirth or death. If the company is moving towards death, its last remaining value will be in its assets. Since it will have little or no future income, income based valuations will be meaningless. If the company is moving towards rebirth, the principles of start-up or growth valuations would apply (see earlier) with consideration for existing asset value. Companies in this part of the life cycle generally offer the best value for a buyer since they can be valued for their assets (which could be sold to recoup that value) but have the upside of a potential turnaround.
Businesses are valued for a different of reasons. For investors, they are valued to see if they can be bought cheaper than they are currently trading. They are hoping to make relatively small returns while keeping risks to a minimum. For sellers and buyers of private businesses, they are valued as a starting point in a negotiation. As such, the function of the value is to bring the right people and businesses together. The sellers starting value determines the depth of the pockets of the buyers he attracts. Whether they see similar value in the business will be determined during the negotiation (See my blog on "Business Negotiation") and will ultimately determine the fate of the business sale.
Once it becomes evident that there is an opportunity for a business deal, the buyer and seller of a business need to come together and negotiate the details of that deal. Negotiation is the process where the different parties work out a mutually beneficial agreement regarding the businesses value and conditions of the share ownership change. The study of negotiation draws on ideas from game theory (for the theoretical outcome between purely logical negotiators) and psychology (for the emotional and human angle). Game theory often assumes perfect knowledge of all mitigating factors that could affect the deal. Unfortunately, in business negotiations at least some of that knowledge is unattainable (or even suppressed) or interpreted differently by the negotiating parties. Also, the effects of emotions (especially negative ones) on negotiations distract from the logic of game theory. These two factors form the greatest unknowns in predicting the outcome of a negotiation.
The intentions of the negotiating parties generally guide the ethos of the negotiation and its progress. If all parties are intent on finding a mutually beneficial arrangement and are willing to make concessions, the negotiation will generally lead to innovative and collaborative solutions to problems that could derail the deal. If one of the parties intends to “beat” the other, the spirit of the negotiation will be much more competitive and confrontational and is likely to leave all participants feeling battered. The adage: “it’s not a fair deal until both parties are willing to give up on it” comes from this confrontational approach. Both approaches are used during business negotiations depending on the strength of the respective negotiators’ positions and the likelihood that the negotiators will work together after the deal is concluded.
Confrontational business negotiations come about for several reasons:
When negotiating for a business one generally needs to come to terms on the value of the business given its current state and its future prospects as well as any conditions attached to the business deal. Invariably, the negotiating parties will have different views on the value of the business based on the information and assumptions that they have about the business and its prospects. They will also have different intentions for the business deal. The seller will want to get the maximum value for the business while the buyer will want to negotiate the lowest price. These intentions mean that the negotiators will be naturally inclined to opposition which could in turn encourage one or both of them to use tactics that may trick or lead the other party astray (e.g. Withholding or obscuring information or low/high-ball offers). For negotiators with dubious ethics (especially on the sellers side) these types of negotiations become a balancing act between getting their way by their means and being able to deny culpability after the deal is done (when all information and tactics generally come to the fore). The level of polarisation between the competing intentions (and values) will determine whether a negotiated settlement can be reached and how hard it might be. Negotiations can also be influenced by a previous relationship between negotiators (if the buyer and seller have worked with each other before) or lack thereof (one is less worried about hurting the feelings of someone one is likely to not see again after the transaction is done) as well as the extent of the deal (e.g. buying a portion of a company means one needs to work together afterwards). A collaborative negotiation (see next paragraph) can descend into a confrontational one if one of the parties decides to play dirty later in the process. It is very unlikely to go the other way though.
The alternative to confrontational negotiations are ones where both parties are attempting to find a solution where all parties win. The intention of the negotiation is to find a settlement where both parties walk away with a larger cake to share rather than a larger slice of the existing cake. To keep a negotiation in this realm requires:
Negotiations in business have a tremendous scope to be win-win because there is no limit to how a deal could be structured. E.g. If a seller wants more money than the buyer has upfront he may be willing to yield on the payment terms. Similarly, a buyer may be willing to pay more if the seller continues for a few months to ensure a smoother ownership change and some training. As mentioned before, collaborative negotiations can descend to confrontational ones and are very unlikely to develop after having started in a confrontational manner.
Recent studies suggest that humans suffer from informational overload leading to decision apathy if they need to base their decisions on logic alone. Emotions help us make decisions quickly and they have been shown to be remarkably accurate. Thus emotions can never be removed from a decision to buy a business. That however refers to the emotions relating to the buying decision. The emotions aimed at the opposing negotiator can become a hindrance during the negotiation process (especially the negative ones). If a negotiator’s reactions are driven by emotions, they can eventually lose out in the negotiation because their emotions will betray them or they can be exploited. This is why it’s often recommended to have an emotionally non-involved proxy (such as a business brokers – see "Business Brokers – What’s their purpose anyway?") during negotiations even with the extra layer of complexity this invariably adds.