Hello again,

An interesting question and one that probably every business broker in the world can relate to!

We are in a recession and as such it is certainly more difficult for any party to complete a transaction but it is made especially hard when the lawyers forget about the commercial aspect of a transaction and get caught up in their little closeted worlds.

There are always two sides to any transaction, there will always be risks for both parties, there are always timelines associated with every transaction and the only way to keep this on track is communication. Why then in many cases doesn’t this apply to lawyers? The best lawyers I have dealt with in my years as a broker are those who are willing to be part of the process not sit in their offices working to their own timelines and thereby frustrating the deal. If you interact with the parties you gain a better understanding of the deal and the parties associated with it.

When the lawyer for the Seller won’t talk to the broker who is also working for the seller you know as a broker you have a problem. You market the business, work through the process with all the buyers who respond, get those who wish to proceed to paper, work through the commercial side of the Due Diligence with the successful purchaser and now all you need to do to complete the deal is write up what has been agreed by the parties. Sounds easy but all Lawyers are not created equal. Why can a due diligence process take 2 weeks and the resulting final paperwork still not be completed after 3 further weeks? Billable hours maybe? A Jesus complex? Or is it just as simple as the fact that these companies are there to make money for their partners after all, and will promise the world up front and then allocate the work to an overworked underling and you will get your advice when they are ready no matter the deadline. What are you going to do, sue them?

Please don’t get me wrong not all lawyers are like this. I have recently had a couple of great conversations with Lawyers who are equally frustrated with their own fraternity. One in particular who has decided to downsize his company to a size where there are just two partners, like Paul and I here at Switch, who are comfortable with the quality of each other’s work and have no issues with multiple personalities of a larger team.

Any business broker worth his/her salt realises that both the buyer and the seller in any transaction need to have legal advice to protect their interests in any transaction. That is a no-brainer but the keyword is advice, and the good ones realise that to get a deal done their client is going to have to make some concessions and take some risk. Their job is to minimize that risk but there is no way to eliminate it entirely if a deal is to be completed, advice needs to be given, ramifications need to be explained and the client needs to then decide if it is a risk worth taking. If business was risk free everyone would be doing it.

There are always timelines in any transaction and Lawyers have to start adhering to them. If their workload means a deadline can’t be met then don’t accept the work in the first place. We have recently had an instance where a lawyer who was allocated the job in a large firm to write up a S&P for the purchaser of a business we have been marketing get seconded to a larger transaction and no-one was told. The purchaser, her client, just stopped getting calls for a few days. The worm can often turn in any transaction and often does when timelines don’t get met and the purchaser begins to develop buyer’s remorse. And for the seller, when the buyer walks away from a perfectly good deal, the process has to start again. But the lawyers still get paid.

So please understand I am not bagging all lawyers, just the same way as I say that my own conduct is not perfect on every deal, but if we are all trying to see if we can get a deal together then join the team rather than sit in isolation on the sidelines.

If you don’t have experience in commercial transactions say so and either get advice yourself or pass the transaction onto someone at your firm that does have the necessary experience to move the transaction forward. The transaction is not about you or the accepted processes you as lawyers like to adhere too. So get with the program and join the process, gain an understanding of the transaction, of the people involved and then advise accordingly

With the recession continuing to bite, you almost have to stay away from the business pages, because every other day there is a ‘poll’ that says business confidence has plummeted and the new coin of phrase is ‘double dip recession’. But business still carries on.

One interesting wrinkle that raises its head for Paul and I as business brokers in these tough times is the owner’s personal debt situations influencing their expectations on the value of their business.

Or as has recently happened in a small transaction we have been involved in, where the proceeds of the sale, and the payment terms that have been agreed upon do not give the owners the funds required to fully repay their debt to their financiers and thereby they are unable to release the charges on the business and therefore cannot settle.

Their personal situation becomes the fore front of their minds and even though they have an unconditional deal, which they have also signed as covenantors, they have tried to bully the purchaser into changing the terms of the contract to suit their personal situation, so they can settle. If they had been a little more honest and forthright about their personal situation we would have negotiated more suitable terms on their behalf with the purchaser initially, but instead after following their secret squirrel approach they tried to modify terms the day before settlement. This is hugely unsettling to the purchaser because he wonders where he stands trusting the owner to properly transition the business. Lawyers then start to dig their toes in on both sides and we sit at our desks twiddling our thumbs waiting for the dust to settle. All because our clients failed to separate their personal situation from their business.

We have also this week been helping a purchaser look through another deal, which we are not selling. A significant business, but it also is a business with significant debt. The owner’s accountant has been attempting to help him sell down 50% of the company to be able to repay $1.4m debt to the bank.

So the accountant comes up with a valuation based on a $600k EBIT of $3m which conveniently would offer the owner the ability to sell 50% and clear his debt. Just on the top-line of this valuation it is fantasy and if the same accountant was working for the purchaser he/she would value to business at most at around $1.8m. The cynic in me says this is a good way for the accountant to get his/her fee by telling the client what he wants to hear.

As I have mentioned in previous posts a business value is generally based on a capitalisation rate/multiplier on what the sustainable earnings of the business are. The setting of the capitalisation rate/multiplier is based on the risks to that income, not what the owner wants or needs!

These situations often come up because business owners strip too much money from the business when things are going well and have to borrow to cover the shortfall when things start to fall off. Also when times are good lenders are often in business owners ears encouraging them to take on more debt and these loans often are for discretionary purchases. The hens come home to roost when times get tough and there isn’t enough working capital in the business to operate day to day.

Any business is worth what it is worth based on the sustainability of its income not what the owner wants or needs from the transaction.

Small to medium business owners often have no real idea of what makes up the value of their business when they come to sell. An area where there is often confusion is the impact that the tangible assets of the business, in most cases Stock + Plant & Equipment, have on the value quoted.

Most SME businesses in the NZ market will be valued by Business Brokers or owner’s accountants using a ‘Capitalisation of Future Maintainable Earnings’(FME) methodology or something similar. We assume that a SME is a business that offers a return on investment after an owner’s salary, in most cases has a management structure rather than the one man band type business.

Capitalisation of FME in simple terms involves the calculating of a net surplus figure for the business, quoted in most cases either as EBIT (Earnings Before Interest and Tax), EBITDA (Earnings Before Interest, Tax, Depreciation or Amortisation) or EBPITD (Earnings Before Proprietor’s Income, Interest, Tax and Depreciation) which is most often used for owner operator sized businesses. This figure is often based on an average of the last three years performance of the business for mature businesses and in some cases on the current year if the business is growing or declining.

A capitalisation rate or multiple is then set to reflect any positive or negative factors that have been identified, which could influence the businesses ability to earn that figure going forward. For example a SME with little risk could have a capitalisation rate somewhere in the range of 25-32% on EBIT or multiple of approx 3-4 times EBIT where a SME in the same industry which has risk could be somewhere in the range of 33-40% on EBIT or 2.5-3 times EBIT.

One of the assumptions utilising the Capitalisation methodology is that the value that is agreed to includes all of the tangible assets required to run the business in its current form. So all the normal stock requirements and all the normal Plant & Equipment required for the day to day operation of the business are included.

Now this is where things can get tricky because business owners everyday make decisions on the levels of the tangible assets of their business and these are often not reflective of what the business requires going forward.

The level of stock that a business holds at the point of valuation has nothing to do with setting the value of the business using the capitalisation methodology i.e.

Business A: EBIT $250,000 Cap Rate: 25% Value: $1 million

If Business’A’ currently has a stock holding of $500k or $1,2m it is still worth $1million utilising capitalisation methodology. So it is in a business owner’s best interest to keep their stock holding to an efficient but acceptable level. If the stock holding required for business ‘A’ to operate is $600k but there is only $500k on hand then the owner will have to either increase stock levels to the required level or have the sale price reduced accordingly.

The same can be said for the plant and equipment required to run the business. All the vehicles, fork hoists, computers, furniture etc. required to run the business day to day is included when using this valuation methodology.

There is no need for guess work here though for a purchaser. A good robust Due Diligence investigation utilising a good commercial accountant experienced in this type of transaction can accurately identify whether the levels of either stock or plant and equipment indicated on the Sale & Purchase agreement are at a level suitable for that transaction.

We also recommend though that the owner of any business that wishes to sell has an equally robust conversation with their accountant and/or business broker to identify what the true levels of each should be before the business hits the market. It is certainly better to have the business positioned correctly to all parties rather than having the business enter into a Due Diligence investigation, which incurs costs on both sides, and have the transaction fall over because of a perceived dishonest approach by owner, broker and accountant.

If you are thinking of selling your business and are unsure of where your business stands relating to any of this please feel free to contact Switch Business.