Selling your company is likely to be a once in a lifetime experience. It is essential you get it right.
What do you want to achieve from selling your company?
Are you looking to maximise the proceeds or are you also concerned about the welfare of your employees, the integrity of the purchaser and its plans for your business, how much tax you will have to pay and what type of payment is being offered?
Do you want to sell outright or are you only looking to sell a minority shareholding to a trade partner or institutional investor? Do you want an on-going involvement in the management of the business and do you have family members working in the business who may wish to stay after a sale?
What is your timetable? Is it influenced by your expectations about the future performance of the business, your personal tax situation or your state of health?
Do you have a preference for who you wish to sell your business to?
Are there other owners whose consent will be required and do they have meaningful shareholdings?
There are so many permutations to consider it is really important for a vendor to think carefully about his or her objectives. Selling your business will be stressful, may involve difficult negotiations and require you learning a lot of new things. It can place personal relationships under severe strain and give rise to damaging disputes when family and other shareholders have different agendas.
Equity Strategies can assist you in framing your objectives and in anticipating obstacles. It may be the first time you have sold a business but rest assured it is not our first time. We bring a wealth of experience to help you cope with this once in a lifetime and very important transaction.
For years you will have been focussed on boosting sales, growing profits and dealing with the myriad of problems running a business. You may have given little time to considering how your business would look to an outsider. You may have relied more on your business instincts and managing the company’s cashflow than producing voluminous management reports, ratios and KPIs. Your personal affairs may be so interwoven with your company it is impossible for a prospective buyer to establish the underlying performance of the business.
If you wish to maximise sale proceeds and keep the process on track you will need to get the business ready for sale.
The key steps in preparing a business for sale include some or all of the following:-
Smart Education Ltd runs a profitable private school and sixth form college from freehold premises in Chelsea, London. The property is situated in a prime residential road and has been professionally valued at £10m on an alternative use basis (net of refurbishment costs estimated at £1.5m) but is valued at £6m on an existing use basis in the Company’s Balance Sheet. Smart Education generated pre-tax profits of £1.3m in the year just ended. Other than some general maintenance costs there were no other property related costs charged to the profit and loss account.
Smart Education has received an unsolicited offer for the entire business valuing it at £12m, approximately 12x its post-tax profits. In the eyes of the owner of Smart Education it feels like he is getting just £2m for the business as he values the property at £10m.
One solution is to lease the property back to the business based on its existing use value, say £300,000, which represents a gross yield of 5.0% (the actual yield will be influenced by the quality of the tenant’s covenant and the duration and legal form of the lease). Pro-forma pre-tax profits are reduced accordingly to £1m and post-tax profits to say £750k. Assuming the acquirer is only prepared to value the business on a multiple of 10x earnings without the property (as it cannot borrow as much), the business is now valued at £7.5m.
This option gives the owner of Smart Education £7.5m in cash for the business and the ability to retain ownership of the property worth £6m (on an existing use basis) with a potential further gain of £4m if the property is refurbished and sold at the end of the lease for residential use. Total pre-tax proceeds could eventually top £17.5m if he retains the property against just £12.0m if the whole business including the property is sold now.
The reasons for these valuation anomalies are twofold. First, the property used in the business may have more value if used for a different purpose. Second, freehold property is often valued on a higher multiple of rental income than a company is valued on a multiple of its profits. In this example, the freehold property is being valued at £6m on a 5% yield which is the same as saying 20 times the rent. Adjusted for tax (assumed to be 25%), the yield drops to 3.75% or a multiple of 15 times the rent, which is higher than the 12 times post-tax earnings Smart Education is being valued by the acquirer. Sometimes these valuation differentials can become acute.
The only problem with the solution discussed here is that splitting out the property from the Company may give rise to adverse tax consequences. If the property is transferred to the existing owners prior to a sale it will be treated as a distribution or dividend and be taxed at the vendor’s highest marginal rate of tax. One way around this would be to leave the property in the Company and instead sell the goodwill and assets/liabilities to the acquirer. The profit on the disposal would be subject to corporation tax and be payable by Smart Education. The Company would then be liquidated and the distribution to the owners (in the form of property and the cash from the sale of the business less the corporation tax paid) would be treated as a capital distribution and be subject to Capital Gains Tax and not Income Tax. If the vendors qualify for Entrepreneurs Relief they will only pay 10% CGT on the first £10m of lifetime gains and 28% on the balance.
Owners will need to consider carefully the trade off between holding onto a property when selling a business and (probably) paying more tax versus selling the company with the property and benefiting fully from Entrepreneurs Relief and lower taxes. If the company is owned equally by a husband and wife the benefit of "double" Entrepreneurs Relief might tip the balance in favour of selling out completely and paying just 10% tax.
In the example below we look at an education company with too much cash on its balance sheet.
Sporty Rights Ltd generated pre-tax profits of £500k in the year just ended (excluding the interest on any surplus cash). The owner has taken only modest dividends in the past and the Company has surplus cash of £3m, none of which is required for working capital. In preliminary discussions with Ring Ring plc, a value of £3m has been placed on the business valuing it at 8 times its post-tax profits, excluding the surplus cash. The owner of Sporty Rights plans to distribute the surplus cash as a dividend prior to sale.
Following a meeting with his tax consultant, the vendor is advised to seek a change in the terms of the offer.
Under the terms of the original deal, the vendor would have paid tax at a rate of 42.5% on the pre-sale dividend, a tax charge of £1.275m. He is advised to persuade the acquirer to increase the offer to £6m but leave the surplus cash in the company. In this case, the extra proceeds are treated as a capital gain and are subject to CGT rather than income tax. If the vendor qualifies for Entrepreneurs Relief which taxes the first £10m of lifetime gains at a rate of 10%, the tax charge on the additional £3m of consideration will be £300k, a meaningful saving of £975k.
On occasion, a prospective purchaser may have reasons for not wishing to co-operate with this solution because it increases the headline purchase price causing presentational difficulties, even though the economic substance of the transaction has remained the same. There are also some legal complications, most notably around financial assistance, but these can normally be resolved.
The grooming process will usually take anywhere between 6 months and 2 years. Do not be tempted to go overboard as more experienced acquirers will quickly see through any obvious window dressing.
Once your objectives are established and the business has been prepared for sale, the disposal process can commence in earnest. Typically, the work performed will be along the following lines:
3.1 Identifying potential buyers
Identifying potential buyers using various third party subscription based or proprietorial databases, your adviser’s contacts, your own personal knowledge of competitors, trade magazines, financial press and internet searches. An adviser may be particularly useful in identifying the less obvious purchasers who may be prepared to pay a premium to enter the market, e.g. a company in a related sector or an overseas buyer. Also consider approaching the senior management team to see if they would be interested in pursuing a private equity backed bid.
The development of the internet has transformed the search for prospective purchasers and greatly expanded the pool of prospective buyers. Equity Strategies has access via a specialist database to over 5,000 live buy mandates covering all business sectors allowing us to make discrete approaches to potential purchasers on a worldwide basis. We also have access to financial and ownership data on up to 20 million privately owned companies across the globe.
It is important to form some preliminary opinions on the range of values for the company as this may influence which potential buyers are approached. Obtaining a valuation opinion from an adviser is particularly important where the business is not being sold by way of an auction and a benchmark is required to assess a single offer. It can be tactically convenient in a negotiation for the seller to argue it cannot accept an offer which is below the valuation produced by its adviser. You will need to be realistic about the value of the business being sold. As evidenced by BBC 2’s Dragon Den show, business owners have a natural tendency to overvalue their business so the price needs to leave something on the table for the other side.
Equity Strategies has a deep understanding of the various methods used to value a whole company or a shareholding and has access to both proprietorial and third party database of recent transactions. Different sectors may adopt different approaches to valuation. Property and non-life insurance companies are typically valued by reference to tangible net asset value, growth companies by reference to discounted future cashflows or sales revenue and non-growth businesses by reference to free cashflow yields. Profit always plays a role in most valuations, whether historic or anticipated and whether struck at a company’s earnings before interest, tax, depreciation and amortisation (“EBITDA”), EBITA, EBIT or post-tax level. Total debt and surplus cash also play an important role.
The ability of a purchaser to create synergies on an acquisition may result in higher valuations. Equity Strategies focus on the key value drivers in a business and how they might be fully exploited by an acquirer.
Determining the most appropriate sale method often comes down to deciding whether a company should be auctioned or be sold through a negotiated sale process.
Advantages of an auction:
An auction is likely to maintain competitive tension throughout the due diligence process and completion stages of the transaction. The preferred bidder will know there are other serious bidders able to step into its shoes should negotiations stall. Although an auction will take more time to organise, once a preferred bidder has been selected the deal should complete more quickly.
Disadvantages of an auction:
There are significant advantages of requiring short-listed bidders to undertake due diligence before submitting their final bids. By maintaining competitive tension for longer this method reduces the prospect of a buyer seeking to salami slice the deal. Another approach involves the vendor’s legal adviser drafting all the key legal documents in advance and asking short-listed bidders to agree to these or mark-up required changes when submitting final bids. Understandably, prospective purchasers dislike these techniques, not only as it limits their ability to subsequently manoeuvre on the terms of their offer but also because it can make bidding expensive without there being any guarantee of a successful outcome. A balance is always required between the need to maintain competitive tension and not deterring bidders because of high bidding costs;
Preparing an information memorandum to provide details about the company’s operations, financial background and any future plans. It is important to bear in mind this document is a selling document and its main purpose is to encourage prospective purchasers to submit a bid. The level of detail provided in an information memorandum depends on the size and type of business being sold. If the company is unique and bids are being sought from potential new entrants to the market, a detailed document will be needed to fully explain the product or the services and its market potential. If the likely bidders are companies in the same sector it may be possible to simply invite initial bids on the basis of audited and management accounts and any other specific information requested by the prospective buyers. This approach will keep your costs down but may require a prospective purchaser to spend more on due diligence later in the process. Also, if prospective bidders are likely to include your competitors you may not want to disclose too much information until you are confident they are serious;
In theory, it is a good idea to leave face to face negotiations to an experienced adviser as this allows the owner to remain on good terms with the purchaser, which may be useful if the negotiations run into difficulty. In our experience business owners generally do not like to take a passive role. It is not in their nature! We recognise this and adopt a more collaborative style which we find works well.
A good negotiator will use many of the following techniques:
A purchaser will typically wish to undertake detailed due diligence. This process of checking and verification will typical cover commercial, accounting, tax and legal issues. Due diligence normally takes between three and four weeks on a typical deal but there are buyers who take a more instinctive approach, rely more on trust and look to complete a transaction more quickly.
To ensure due diligence is completed on a timely basis, it is important all the relevant information is made available, often in a dedicated space or data room.
A buyer is likely to seek extensive warranties covering such issues as the title to the shares, the accuracy of the audited accounts and management accounts, title to assets held by the company, the existence of any litigation against the company and any other contingent liabilities. A vendor will seek to limit the scope of the warranties and also place a cap on the amount which can be recovered under a warranty claim; and
If only one party is invited to undertake due diligence it is normally sensible to agree the outline terms of the deal in a Heads of Agreement. Although not legally binding, it will assist the lawyers in drafting the sale and purchase agreement and other legal documents. It can be used to assert moral pressure on a purchaser who seeks to move away from the terms previously agreed. Once broad terms have been agreed and due diligence has been completed, the legal advisers on both sides will negotiate through to completion. Solicitors have a habit of complicating the simplest of deals, often for good reason but occasionally because they have failed to understand the commercial significance or otherwise of a particular issue. It is generally a good idea to keep your legal advisers on a short leash, focussed on the commercially important issues and key risks which should keep the transaction moving and legal fees down.
Deals involving a business which is anticipated to grow significantly in the future but where there is no certainty of success or which is very reliant on the services on one or two key individuals may benefit from part of the consideration being structured as an earn-out. These arrangements may take many different forms but typically involve the payment of additional consideration if certain pre-determined profit targets are achieved. They need to be structured carefully to protect the interests of the seller, especially if they will no longer be involved in the business after the sale. Earn-outs can be taxed before they pay-out so getting advice here is critical.
Earn-outs can play a useful role in bridging any difference between the parties’ expectations on price.
Most corporate transactions involve the payment of cash on completion. On occasion, the purchaser may offer a combination of cash, vendor shares and/or loans notes. Although, this mix may have allowed the purchaser to pay more for the business than they might otherwise have done, can be advantageous from a tax point of view and might result in spectacular gains if the price of the purchaser’s shares rocket, there are also many risks which expose the vendor to potential and significant losses.
A detailed financial analysis is required of the purchaser to assess its trading performance, solvency and the robustness and durability of its business model. Attention needs to be paid to the market value of the purchaser’s shares. During the dot com bubble in the early 2000’s quoted company valuations soared, sending P/E ratios on many non-IT stocks to over 30 or 40 time earnings. Deals struck at elevated price levels have a nasty habit of disappointing in the long run.
Loan notes can make more sense, especially if they are bank guaranteed. Typically, loan notes will need to be structured as non-qualifying corporate bonds (“non QCBs”) to allow gains to be deferred until the loan notes are redeemed. Since 2010, it has not been possible to claim Entrepreneurs Relief on deferred gains, although it is possible to elect to crystallise gains in the year of exchange. This means paying CGT before the non QCBs are redeemed.
Another factor to consider when accepting deferred consideration in the form of loan notes is the effect of inflation and taxation on its real value over time. Many financial commentators argue higher inflation in the future is the natural consequence of today’s policy of quantitative easing. Fixed interest instruments will be the obvious casualty if the high inflation thesis is proved correct. A loan note offering a 3.5% yield is already offering no real return when taking into account inflation and after taxation will be offering a negative real return.
It is not entirely out of self-interest we believe a financial adviser is important to the vendor. Selling a business is a very time consuming and stressful process. There is a very real danger of an owner becoming so involved in the sale process he or she takes his eye of the ball to the detriment of the business. Using an adviser to manage the sale process, make introductions to potential buyers, provide valuation advice, structure the deal and any related earn-out, to advise on tax matters and lead negotiations is invariably the best way forward.
In selecting an adviser it is particularly important to establish they understand the sector in which you operate, the key developments affecting the market, corporate activity and know the main players and personalities.
Most advisers charge a success fee on a percentage of the deal value. They normally charge a retainer at the outset and request further payments as each milestone is achieved. These interim payments are deducted from the value of the success fee. Vendors should expect to pay total professional fees (i.e. including legal fees) equal to between 2% and 5% of the value of the deal in the mid-market arena. Fees will be at the lower end of the range on larger transactions and will be lower the simpler the sale process.
If you are considering selling your business we would like to meet you on a confidential basis to discuss your objectives, without commitment or charge. Please call Leon Boros on 0208 240 6643.
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