Buying a business – buyer beware?

As with any investment, it pays to know and understand as much as possible of your potential business venture. Particularly when your client is considering buying a business.

At the core, it is up to the buyer (and their advisers) to make sure they are buying a profitable and sustainable business.

Due diligence is a must in our current economic landscape as some business owners may endeavour to present the financial outlook or performance of their business in a favourable light. It is up to the prospective purchaser to ensure the business is truly performing as expected.

To get a good return on your client’s investment, the business needs to be fully analysed and the right questions need to be asked. If in any doubt whatsoever, the prospective purchaser should simply walk away.

Being thorough is absolutely crucial.

Knowing and understanding what a business is truly worth will not only give your client the confidence to offer a realistic and fair price for the business, it can also prevent some serious and unnecessary financial ramifications in the future.

So what’s the best way to purchase a business?

There are generally two ways an investor goes about acquiring a business:

• buying the assets of the business
• buying the shares of the company that owns the business.

Which option is best for your client?

Here a few things to consider, but this is an excellent opportunity for lawyers and accountants to work together to pinpoint the best option for their mutual client.

Buying assets

Businesses are often divided into three parts when they’re valued:

• tangible assets (such as premises, machinery and vehicles)
• stock (such as materials and supplies)
• intangible assets (such as exclusive contracts and patents or goodwill)

For smaller businesses, this is the most common option as it allows the buyer to avoid any inherited historical issues, or claims that might be made against the business.  In short, the buyer acquires the assets and not the liabilities of the business.

The buyer, however, must understand what securities (if any) have been registered over the assets of the business and ensure those securities are released at the point of sale. Failure to do so could lead to those assets being repossessed by the secured party if it turns out the original company is behind in their obligations.

Buying shares

The other approach is to buy shares in the company that owns the business.

The mechanics are much easier as the buyer simply buys the shares of the legal entity that owns all of the business assets.

Buying shares virtually eliminates the need to transfer title to all of the many different assets used in or by the business. It can also eliminate the need to transfer, renegotiate or reapply for things such as permits, utilities, facilities leases and employment agreements.

However, the possible downside for the buyer with this option is that the buyer is then inheriting any undisclosed liabilities associated with the business.

When determining the value of a business, a professional should always be involved. Knowing what questions to ask is critical to ensure, not only that your client is paying the right price for the business, but that it remains a business worth buying. As chartered accountants, Gerry Rea Partners works with lawyers and accountants to arrange business acquisitions in ways that minimise risk.

If you have clients looking to procure a business and require assistance in gauging options, please email Simon at sdalton@gerryrea.co.nz. We’d be happy to help you find the best solution for your client.

The majority of the businesses we value fit the definition of a small to medium sized enterprise, referred to as an SME with a business activity that can be expected to operate indefinitely. The directors, who are almost always the shareholders as well, are involved in the day to day operation of the business. If they ever want to quit the business, 99% of the time the company will sell the business rather than the shareholder selling their shares. Nobody wants to buy the shares which may have any number of skeletons in the closet.

The agreement for the sale and purchase of a business will normally only include stock, fixed assets and goodwill. The company selling the business is responsible for the realisation of receivables and other assets and the payment of all liabilities.

Logic would suggest that the best way of valuing the shares in such circumstances would be to simulate the same process and establish what the business could be sold for together with the realisable value of the other assets, minus the liabilities that must be paid – effectively a hypothetical liquidation.

In New Zealand we are fortunate to have a company, Bizstats Limited, that collects data from business brokers throughout New Zealand on the sales of businesses. The data from selected business sales (similar business activity, comparable turnovers or profitability) can be used as a basis for estimating what the business of the company might sell for – a direct market comparison.

One of the key points with the Bizstats data is that the profitability measure provided is the “Seller’s Discretionary Cash”. This is the cash income available to the owner, assuming he or she provides all the funding (no interest deducted) after adding back all discretionary expenditure such as entertainment, donations and overseas travel, unless these expenditures are absolutely obligatory. These obligatory expenditures, however, exclude the requirement to compare a fair market salary, making the valuation exceedingly difficult to define. This could potentially require the input of an HR expert.

We consider the Bizstats data and the valuation simulation of a sale on this basis is often more reliable than the more hypothetical capitalisation of future maintainable earnings, normally Earnings Before Interest and Tax (EBIT).

The difficulty with this method is that one has to assess a fair market salary and a discount rate (or its inverse, a multiplier). We have had a few debates with other valuers over a fair salary. Does a person who is technically qualified to do the job of running the company get extra income for the management of staff, the marketing of the company business and the financial management of the company? This would depend on the number of staff and the size of the company. We don’t think managing a staff of one or two would cut the mustard.

The biggest hypothetical factor is the determination of the return on investment. There is no empirical data that establishes what return on investment is applicable.

We can of course come up with a number based on some empirical data. We have seen colleagues look at the returns on investments from published data of takeovers of US companies in the billion dollar range as the basis for assessing the value of a company valued at $4.0m. However, we are not convinced that an adjustment for the size difference would add validity or robustness to the value of the SME.

In establishing a desired return on investment, forensic accountants may start with the risk free rate of return which is assumed to be the return on the long term government stock to which is added: a premium for being in the sharemarket, which is hypothetical in that the shares in closely controlled companies are very rarely sold; a premium for small company risk, the amount of which is at best an estimate and impossible to empirically justify and a premium for lack of lack marketability. Again a hypothetical amount in the shares in public companies can be sold on the stock exchange and shares of companies operating SME’s practically are not.

If we are valuing less than a controlling interest there is an argument for a discount for lack of control. In the US, there is a source of data that considers the percentage difference between acquisition price and the listed price five days before the announcement of the acquisition or merger. Unless one is valuing for an acquisition or merger, the value is never tested. Merger stats in the US have data from 10,106 transactions which show that from 1998 to 2015, the average control premium ranges from 33.2% in the UK to 9.0% in Italy with Australia at 30.4%. In promoting the sales of their data, Merger stats suggest that by using its data one can defend one’s control premiums and minority discounts with “absolute confidence”.

Again if we are talking about a company 100 fold greater than the SME, is that empirical data a valid comparison?

Our conclusion: if one is able to use the direct market comparison with little requirement to adjust for size and profitability then the valuation could be considered reasonably scientific. Once one has to make adjustments to parameters supported by empirical data for significant variances in size and profitability of company, then the valuation shifts away from a science to…more of an art form.

The science is picking the right data; the art is adjusting the parameters from that data for the current valuation.

What is your take on valuations? Is it an art form or is it a scientific approach? Can it be both? Any feedback, inquiries or comments are welcome. Please email John at jleonard@gerryrea.co.nz or Matt at mkemp@gerryrea.co.nz.